• To analyze the existing financial mix of the firm and to assess, from a qualitative trade-off between the benefits and the costs of debt, whether the firm has too much or too little debt, try answering the following questions:
To answer these questions, you might want to look at the following
1. Benefits of Debt
o What marginal tax rate does this firm face and how does this measure up to the marginal tax rates of other firms? Are there other tax deductions that this company has (like depreciation) to reduce the tax bite?
o Does this company have high free cash flows (for eg. EBITDA/Firm Value)? Has it taken, and does it continue to have good investment projects? How responsive are managers to stockholders? (Will there be an advantage to using debt in this firm as a way of keeping managers in line or do other (cheaper) mechanisms exist?)
2. Costs of Debt
o How high are the current cash flows of the firm (to service the debt) and how stable are these cash flows? (Look at the variability in the operating income over time)
o How easy is it for bondholders to observe what equity investors are doing? Are the assets tangible or intangible? If not, what are the costs in terms of monitoring stockholders or in terms of bond covenants?
o How well can this firm forecast its future investment opportunities and needs? How much does it value flexibility?
Part VI. Optimal Capital Structure
• To assess the optimal financing mix of your firm, try the following questions:
1. Cost of Capital Approach
o What is the current cost of capital for the firm?
o What happens to the cost of capital as the debt ratio is changed?
o At what debt ratio is the cost of capital minimized and firm value maximized? (If they are different, explain)
o What will happen to the firm value if the firm moves to its optimal?
o What will happen to the stock price if the firm moves to the optimal, and stockholders are rational?
2. Building Constraints into the Process
o What rating does the company have at the optimal debt ratio? If you were to impose a rating constraint, what would it be? Why? What is the optimal debt ratio with this rating constraint?
o How volatile is the operating income? What is the normalized operating income of this firm and what is the optimal debt ratio of the firm at this level of income?
• To analyze whether the firm has too much or too little debt relative to the sector and the market, try the following:
1. Relative Analysis
o Relative to the sector to which this firm belongs, does it have too much or too little in debt? (Do a regression, if necessary)
o Relative to the rest of the firms in the market, does it have too much or too little in debt? (Use the market regression, if necessary)