Teresa, the owner of Stack Brewery, recently met with a consultant who advised the firm that it was “under-leveraged” and should be “recapitalized”. She had always financed the firm entirely with her own funds and having feigned comprehension at their meeting, wondered exactly this could mean. Briefly explain what condition(s) would be necessary to create firm value by swapping equity for debt (borrowing money against the firm’s assets and paying it to herself as a dividend)
Teresa, the owner of Stack Brewery, recently met with a consultant who advised the firm that it was “under-leveraged” and should be “recapitalized”. She had always financed the firm entirely with her own funds and having feigned comprehension at their meeting, wondered exactly this could mean.
- Briefly explain what condition(s) would be necessary to create firm value by swapping equity for debt (borrowing money against the firm’s assets and paying it to herself as a dividend)
Buoyed by this realization, Teresa wondered exactly how much debt to take on. A cursory search of internet resources pointed to the “Static Trade-off Model”, which suggested there was an optimal ratio of debt-to-equity financing which would maximize the value of the company.
- Briefly explain the two value frictions which impact the firm in this model and describe the “optimal” capital structure in terms of these two concerns.
- Assuming a risk-free rate of 4% and a market risk premium of 5%, what would Stack’s
cost of equity capital be before and after this recapitalization?
Teresa was confused by her result in part c) and wondered whether the consultant knew anything at all about
- Show that Teresa would have more wealth after the proposed recapitalization
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