What are the extraneous factors which impact the ability of a business
to radically alter its debt-equity mix?

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Request for Question Clarification by omnivorous-ga on 13 Jun 2005 20:25 PDT

PPR41 --

Though I have an advanced degree in Finance, I'm confused --
extraneous to what?  The firm?  The industry?  The market?  The
economy?

Best regards,

Omnivorous-GA

ppr,

There are two ways of looking at this.  In theory and in practice.

In altering their debt equity mix, you are referring to altering their
weighted average cost of capital.

In theory, the primary factors beyond a firms control relative to
their  weighted average cost of captial are; 1) interest rates,
2)market risk premiums and tax rates.

As interest rates rise in the broad economy, firms must pay higher
rates of interest to bondholders to attract debt capital.

"The perceived risk inherent in stocks, along with investors' aversion
to risk, determine the market risk premiu.  Individual firms have no
control over this factor, but it affects the cost of equity and,
through a substitution effect, the cost of debt..." (Source:Brigham
and Daves, Inter. Fin Mgt 8ed.)

Tax Rates.  Tax rates are part of the calculation of costs of debt
relative to equity (interest is a deductible expense, dividends not). 
Additionally, capital gains tax changes effect how investors view
buying stocks vs. bonds.  Raising the capital gains tax rate would
make stock gains less attractive shifting investors favor towards
bonds (and vice versa).

From a strictly practical standpoint, investor risk mitigates radical
shifts in debt and equity.

Adding debt, hence leverage, increases business risk as marginal debt
suppliers look at the cash flow risk of a firm making all required
interest payments.  They must be compensated for this increased risk
through higher interest rates and at some point, the cost of equity
becomes more economical. Strained debt costs discourage outside
investors and demand for the firms shares decline, affecting the
overall value of the firm.

At this same time, as debt is added, the equity holders require higher
returns (ROE) assuming more and more of the business risk (they get
paid after the debt holders).

Managing the optimal cost of capital involves setting a target capital
structure and then measuring the overall after tax weighted average
cost of debt and equity.  An optimal mix will eventually occur where
the weighted cost bottoms out and then begins to to rise (due to the
blend of the lower debt cost and higher cost of equity).  The mix of
debt and equity that delivers this lowest cost is the prudent choice
for the firms management.

ppr,

There are two ways of looking at this.  In theory and in practice.

In altering their debt equity mix, you are referring to altering their
weighted average cost of capital.

In theory, the primary factors beyond a firms control relative to
their  weighted average cost of captial are; 1) interest rates,
2)market risk premiums and 3)tax rates.

As interest rates rise in the broad economy, firms must pay higher
rates of interest to bondholders to attract debt capital.

"The perceived risk inherent in stocks, along with investors' aversion
to risk, determine the market risk premium.  Individual firms have no
control over this factor, but it affects the cost of equity and,
through a substitution effect, the cost of debt..." (Source:Brigham
and Daves, Inter. Fin Mgt 8ed. pp312)

Tax Rates.  Tax rates are part of the calculation of costs of debt
relative to equity (interest is a deductible expense, dividends not). 
Additionally, capital gains tax changes effect how investors view
buying stocks vs. bonds.  Raising the capital gains tax rate would
make stock gains less attractive shifting investors favor towards
bonds (and vice versa).

From a strictly practical standpoint, investor risk mitigates radical
shifts in debt and equity.

Adding debt, hence leverage, increases business risk as marginal debt
suppliers look at the cash flow risk of a firm making all required
interest payments.  They must be compensated for this increased risk
through higher interest rates and at some point, the cost of equity
becomes more economical. Strained debt costs discourage outside
investors and demand for the firms shares decline, affecting the
overall value of the firm.

At this same time, as debt is added, the equity holders require higher
returns (ROE) assuming more and more of the business risk (they get
paid after the debt holders).

Managing the optimal cost of capital involves setting a target capital
structure and then measuring the overall after tax weighted average
cost of debt and equity.  An optimal mix will eventually occur where
the weighted cost bottoms out and then begins to to rise (due to the
blend of the lower debt cost and higher cost of equity).  The mix of
debt and equity that delivers this lowest cost is the prudent choice
for the firms management.