Assignment 3|Smithwick

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Florida Atlantic University *

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6804

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Economics

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Feb 20, 2024

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Robert Smithwick 2-1-2024 Assignment 3 Refer to the Cost of Capital Guide by Morgan Stanley (available on Canvas under the Capital Structure module) and answer the questions below in 1-2 pages in Word. Please read the section titled “High-Level View of the Cost of Capital,” and answer the following two questions. 1. Explain one connection between the section and our discussions on capital budgeting/consumption-investment decisions. One connection that stayed true to both pieces was portraying cost of capital as a opportunity cost. From a individual standpoint or a company’s, the measure of expected returns that reflects the return for deferring consumption. We can do this by estimating future values with the use of discounting giving us the present value. Thus giving us the opportunity cost of cost of capital. 2. Explain one connection between the section and our capital structure presentation from last week A connection between the section and capital structure presentation that capital structure does matter. In the M&M’s invariance proposition we saw unrealistic conditions of no taxes, bankruptcy costs, and managerial incentives, that led to debt having no effect on a company. No matter their capital structure. Thus, concluding that capital structure does matter. we also know that company grading comes into effect and plays a role in how much debt can be taken on in relation to a certain interest percentage. Taking on more debt can increase this percentage which can cause financial distress. Please read the section titled “Optimal Capital Structure” and answer the following questions. 3. Explain the trade-off theory in one sentence. Based on the section, mention i) one thing observed in practice that the theory is able to explain and ii) one thing the theory is not able to explain.

Trade-off theory: is the ideal configuration for a company (no company is alike) of capital structure by identifying the ideal trade-off between interest tax shields and financial distress. i) The trade-off theory is able to determine if a company with high or low business risk would be a good candidate for debt or equity. This has been supported with high level data. ii) The trad-off theory fails to explain the variability in capital structures amongst companies in a specific industry. Furthermore, the theory does not explain why companies do not look to change their policies in regard to the trade-off theory. 4. Explain the point the authors are trying to make with their discussion of intangibles. The biggest difference between tangible and intangible investments, and why more companies are turning to towards this investment style. Companies are expenses intangible investment s on their income statement and therefore reduce their pre-tax profit. They do this by recording the asset on the balance sheet and depreciate them over its useful life. The intangible asset is another tax shield tool for companies to use.

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