Capital structure is a major topic in corporate financial management. The way a company finances itself over time becomes apparent by looking at their balance sheet. In the Pacioli Company assets of $299,000 were balanced by $231,000 of liabilities (77.3%) and $68,000 of equity (22.7%). So over time, Pacioli tends to finance itself borrowing 77% and 23% owner investment. What is the optimal mix? Start by reading Finkler Chapter 5.
Calculate the total liability to assets percentage and the total stockholder equity to total assets percentage (these must sum to 100%) as of December 30, 2006 for Stanley Works. Keep a copy of the Stanley Works 10-k and disclosures – we will use it in subsequent assignments.
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Capital Structure (Article)
Traditional finance theory suggests that some debt financing should be used since interest payments are tax deductible (dividend payments to shareholders are not). However, going too far with debt increases the possibility of costly legal entanglements if the company misses (defaults) on an interest or principal payment. Finance theorists can derive optimal capital structure given assumptions about cost of debt financing, cost of equity financing, tax rates, and legal costs related to default risk. The optimal solution minimizes the overall cost of capital, and maximizes the value of the company.
Download the article, Making Capital Structure Support StrategyPreview the documentPreview the document. Read the first 3 pages (down to the heading A practical framework for developing capital structure). The authors discuss additional factors (beyond tax benefits of debt) that need to be considered in deciding on an optimal capital structure.
Write a summary of the article addressing the following points.
1. What is meant by financial flexibility and which financing source (debt or equity) provides financial flexibility.
2. What types of companies should consider greater use of debt financing?
3. What types of companies should focus more on use of equity financing?
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Read Finkler, Chapter 6.
Do Question for Review #9 (flexible budget) assuming expected sales volume of 44,000 units. Use Excel Template #7 and Table 6-4 on page 61 of the text. Enter 44,000 in the middle column of your spreadsheet for units sold and the spreadsheet will then generate units sold if volume is 10% greater or less than expected. The sales price per unit is $4.125; in cell E20 enter =4.125*E18. Enter 0 for Service Contract revenue in cell E21.
For expenses, follow the assumption in Table 6-4 that all expenses are fixed, except for supplies. Cost per unit for supplies is $0.25 ; therefore enter =0.25*E18 in cell E26. For Salaries, Rent, and Other, you will enter the amounts from Table 6-4 in all three columns (by doing so, you will be over-writing formulas in the columns to the left and right of the middle column).
You should find that with 44,000 units profit is $16,500; a loss of $550 if sales fall 10% lower than expected (39,600 units); and a profit of $33,550 if sales exceed expectations by 10% (48,400).