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Optimal Capital structure problems
Finance & Accounting
Pages 3 (753 words)
(Name) (Instructors’ name) (Course) (Date) Capital Structure Memo To: Irving Sharp, Chairman and CEO All Seasons Hotel. From: Dennis Mark, CFO All Seasons Hotel. Date: 3rd December 2013 Subject: Proposed Capital Structure It is important for “All Season” to come up with a specific debt to equity ratio that will optimize the cost of capital of a company.
There is certainty of getting off these ranges. The cost of capital will rise when it is off the range; this is illustrated by a blue line. The overall cost of capital for All Seasons is the cost of equity and the weighted Average. For instance “All season” market value debt is 420 dollars, Market Value Equity is 180 dollars, the cost of debt is 14%, and equity beta is 1.36, while the marginal tax rate is 20%. Taking the company from its inception, “All Season” was financed through equity; therefore, its average cost of capital was similar to the cost of equity. When the company grew, it attracted a track record and the confidence of lenders. When the company increased its debt use, it’s debt to equity ratio rose and the ACC dropped. Essentially, “All Seasons” is undergoing substitution for cheaper debt with expensive equity, hence reducing its overall expenses. Eventually, as “All Seasons debt/equity ratio rises, the cost of equity and cost of debt will rise. The lenders will be interested about the loan risk and the interest rate on the loan will increase. The shareholders will be concerned about the default able loan and will insist to receive higher return rate for the higher risk. ...
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