Question 7

Consider what would happen if Aspeon’s business risk were considerably different
than that used to estimate the financial leverage/capital cost relationships given in the
case.

a. Describe how the analysis would change if Aspeon’s business risk were significantly
higher than originally estimated. If you are using the Lotus model for this case,
assume that the following set of leverage/cost estimates applies:

Amount​ ​Borrowed Cost​ ​of​ ​Debt Cost​ ​of​ ​Equity

$0 0% 17.00%
$25,000,000 11.00% 18.00%
$50,000,000 13.00% 20.00%
$75,000,000 16.00% 23.00%
$100,000,000 20.00% 27.00%
$125,000,000 25.00% 32.00%

What would be Aspeon’s optimal capital structure in this situation?

Amount​ ​Borrowed Cost​ ​of​ ​Debt Cost​ ​of​ ​Equity

$0 0% 14.00%
$25,000,000 8.00% 14.30%
$50,000,000 8.50% 15.00%
$75,000,000 9.50% 16.00%
$100,000,000 11.50% 17.50%
$125,000,000 13.50% 19.00%

What would be the firm’s optimal capital structure in this situation?

Now consider two capital structure theories: Modigliani-Miller with corporate taxes
(MM63) and the Miller model.

a. What would Aspeon’s value at $75.0 million of debt be, according to theMM63
model?

Vu 120,000,000
Tax rate 0.40
Debt 75,000,000

VL = Vu + TcD
VL =120,000,000 + 0.40(75,000,000)
VL $ 150,000,000

b. What would the firm’s value be, according to the Miller model? (Assume that the
personal tax rate on income from stock (Ts) is 25 percent, and the personal tax
rate on income from debt (Td) is 30 percent. Also, use $120 million as the value of
the unlevered firm (VU) in both the MM63 and Miller models, even though it should
be less in the
Miller model.)

Vu 120,000,000
Tax rate. Tc 0.40
Tax rate from stock, Ts 0.25
Tax rate from debt, Td 0.30
Debt 75,000,000

VL = Vu + [1 - (1-Tc)(1-Ts)/(1-Td)]*D
VL = 120,000 + {1-[(1- 0.40)(1-0.25)]/(1-0.30)}x75,000,000
VL $ 146,785,714

c. Why do values differ when calculated by the equations in Question 3, the MM63
model, and the Miller Model? (Hint: Consider the assumptions that underlie each
model.)
 EBIT 32,000,000
D 75,000,000
Kd 0.13
Ks 0.19
T 0.40

S =[EBIT -Kd(D)](1-T)/Ks
S =[32,000,000-(0.13)(75,000,000)]x(1-0.40)/0.19
S $ 70,263,158

V =S+D
V =70.263,158 + 75,000,000
V 145,263,158

In 1958, Franco Modigliani and Merton Miller (MM) proved, under a restrictive set of
assumptions including zero taxes, that capital structure is irrelevant; thus, according to the
original MM article, a firm’s value is not affected by its financing mix.

In the Modigliani-Miller 1963 model, it modifies the original Modigliani-Miller model where
the following assumptions hold true:
 There are no brokerage costs
 There are no bankruptcy costs
 Investors have thesame information as management about the firm’s future investment
opportunities
 EBIT is not affected by the use of debt.
 The last assumption was modified, instead of having no taxes, the tax code allows
corporations to deduct interest payments as an expense, but dividend payments
to stockholders are not deductible.

For MM63, with a tax rate of say, 40%, this implies that every dollar of debt adds about 40 cents
of value to the firm, and this leads to the conclusion that the optimal capital structure is virtually
100% debt. MM also showed that the cost of equity, rs, increases as leverage increases but
that it doesn’t increase quite as fast as it would if there were no taxes. As a result, under MM
with corporate taxes the WACC falls as debt is added.

Miller’s model considered the effect that personal taxes would have. Income from bonds is
taxed as interest while income from stocks comes from capital gains. As Miller pointed out, (1)
the deductibility of interest favors the use of debt financing, but (2) the more favorable tax
treatment of income from stock lowers the required return on stock and thus favors the use of
equity financing. It appears that the presence of personal taxes reduces but does not
completely eliminatethe advantage of debt financing.
The 3rd equation considers taxes but not the effect of personal tax. It also considers that
information is not symmetric. Moreover, risks are considered such as bankruptcy.

Question 9

How do control issues affect the capital structure decision?

Control issues affect the capital structure to influence either using debt or equity. This can be
further described in the “agency problem”. In most businesses, especially the large ones, the
owners and managers have become distinct group of individuals. An inherent conflict exists
between managers and shareholders – for whom managers act as agents in carrying out their
goals. Therefore, agency problems occur if managers and shareholders have different objectives
where ownership and management control are separate. (Titman and Keown, 2014) Example of
this is when times are good, managers may waste cash flow on perquisites and unnecessary
expenditures. Managers may use excess cash to finance projects which have no to less impact
on maximizing the company’s stock prices.

When managers have limited “excess cash flow”, they are less able to make wasteful
expenditures. Firms can avoid these excess cash flow by: 1) funneling some of it back to
shareholders through higher dividends or stock repurchases, or 2) shifting the capital structure
toward more debt in the hope that higher debt service requirements will force managers to be
more disciplined. (Brigham, 2012)

The perfect balance between the use of debt and equity in capitalization shall be in place using
the control of management in the capital structure.
Question 10

a. What are the major weaknesses of the type of analysis called for in the case?

The analysis used in this case requires the assumption of zero growth and perpetual – which
may not be the same in real life applications. The assumptions used in this case may not be
the same in real world. There is no thing as zero growth and debts issued has a well-defined
duration and end.

b. What other approaches could managers use to help determine an appropriate target
capital structure?

The managers can use the actual information from the firm in using a financial
forecasting models for future decision making. They can use and test different scenarios and
forecast corresponding effects to firm’s financials. These test results from actual information can
possibly provide forecasts which is closer to reality. Another approach that managers may use is
the pecking order hypothesis or an approach wherein there is a preferred sequence on how
managers would want to raise their capital: first by spontaneous credit, then retained earnings
then other debt and finallycommonstock. Another isthe windows ofopportunity, wherein a
manager adjust the firm’s capital structure to take advantage of the certain market situations.

c. Is the target capital structure best thought of as a point estimate or as a range?

The target capital structure is best thought of as a range for a number of reasons. First, as
the proportion of debt in the capital structure approaches the optimal level, increases in the
value of the company taper off before declining. The peak is an inverted bowl shape rather than
a point. Also, the weighted average cost of capital initially drops sharply, then tapers off before
reaching the optimal capital structure and increasing. The WACC is bowl shaped rather than V
shaped. Small variations in the capital structure will not have major impacts in the value of the
company or the cost of capital. However,if the company deviates too far from the optimal level,
the company will be undervalued or have a high cost of capital. Second, a firm’s optimal capital
structure will probably vary over time due to changes in the firm’s investment opportunities and
changes in the capital markets. Thus, most firms specify their target structures as a range, say,
40 to 50 percent debt, and then, overtime, take actions to keep the capital structure within the
target range. Of course, they also periodically reexamine the appropriate target range.

d. What other factors should managers consider when setting their firm’s target capital
structure?

Since it is very difficult to quantify the capital structure decision, managers usually consider the
following factors, along with the results from the forecasting model:

1. Assets
2. Growth opportunities
3. Trading on equity
4. Debt and Non-debt Tax shields
5. Financial flexibility
6. Loan covenants
7. Sustainability and Feasibility
8. Degree of Control
9. Choice of Investors
10. Capital Market Condition

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