Answer the following questions
a) What are the potential advantages and disadvantages to a
company’s shareholders if the company increases the proportion of
debt in its capital structure?
Present value of the tax benefit from the future interest payments.
Compared to Greater Financial Risk
b) Distinguish between: business risk, financial risk and default risk.
a. Business risk – the risk of future net cash flows
attributed tot the nature of the company’s operations. It
is the risk shareholders face if the company is financed
only by equity
b. Financial risk – the additional risk borne by
shareholders because of the use of debt as a source of
finance
c. Default risk – the chance that a borrower will fail to meet
obligations to pay interest and principal as agreed
c) With corporate taxes, what is the optimal capital structure for a
company?
Borrow up to the point where the tax benefit from an extra dollar in debt
is exactly equal to the cost that comes from the increased probability of
financial distress.
Borrow up to the point where your weighted average cost of capital is
minimised