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Corporate Finance Case 4 - The Capital Structure Decision and the Cost of Capital

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The background readings of this Module provide plenty of information regarding both the issue of the capital structure decision and the concept of the weighted average cost of capital.
Review the background readings and write a five page paper discussing and explaining the following issues below. Remember that question 4 is the main part of the assignment, it should be roughly three pages out of your five page paper. Questions 1-3 should take up a total of around two pages.
1. What are the advantages and disadvantages of debt financing.
2. How does the use of debt financing affect the rate of return that shareholders require on their investment in the firm's shares. How does the cost of equity (i.e., the rate of return investors require on their investment in the firm's shares) change when the firm increases its use of debt. (This is 'Proposition II" of Modigliani and Miller for the Tax Case - see the first two articles in the required readings).
3. What is meant by "an optimal capital structure of the firm"? Be specific.
4. Now go to the main part of the Case:
Consider three companies: 'General Dynamics', 'Sprint', and 'Dell'. Reflect on the nature of the business of these three companies. You are recommended to also get to the web site of one company in each of these categories. You might also check what the beta of each of these companies is.
Based on the readings of the Module, and upon reviewing the nature of the operations of the companies including the nature of their customers and products, what would you recommend should the capital structure (total liabilities or debt and equity proportions) be for each of the three companies? You should relate your answers to what you wrote in your response to question (3) above. Note that you are not asked to provide specific numbers, just 'low debt ratio', 'medium debt ratio' or 'high debt ratio'. (Do not quote the actual company's capital structure or their debt-to-equity ratios as per their balance sheet.)

Case Assignment Expectations
In the grading of your assignment, you will be assessed on the following items:
1. The use of multiple references beyond just the links mentioned above. Those links are just to get you started, but your ability to do your own research beyond these two articles will be assessed.
2. Your paper from beginning to end on the precise assignment questions. Remember that question 4 is the main part of the assignment. You should provided direct answers to all four assignment questions, but focus on question 4.
3. Your paper should be at least five pages in lengths.

Solution

The solutions provides a detailed discussion of the advantages and disadvantages of debt financing along with a discussion of the impact of debt financing on the rate of return as well. A thorough discussion of the optimal capital structure of the firm has also been included, following which the three companies, i.e. General Dynamics, Sprint, and Dell have been analyzed in detail.

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Corporate Finance Case 4 - The Capital Structure Decision and the Cost of Capital

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