GB550 Financial Management
Unit 5 Assignment
Problems:
1. What is meant by capitalization? What is meant by a firm’s capital structure? For
financial planning purposes, explain why either book or market value should be used to
determine the firm’s capital structure. What is capital structure theory?
Capitalization is the process of evaluation and maximizing a company’s capital
structure i.e. debts and equities. Capital Structure is a firm’s combination of deb
and equity. Capital structure is used to determine the thresholds for debt and
equity a company is willing to accept.
While both book value and market value offer meaningful information, they are
used in different scenarios in business. For financial planning purposes, market
value is best. Investors in business often rely on the market value rather than book
value when evaluating a company (Seth, 2010)
According to Brigham & Ehrhardt (2019) capital structure theory states in a world
with no taxes, the value of a firm and its WACC are unaffected by its capital
structure.
2. Discuss the following issues relating to business risk and financial risk.
a. What is the difference between business risk and financial risk? Explain some of the factors
that contribute to each. Evaluate Moore Plumbing Supply’s level of business risk.
Business risk is the risk a company’s common stock holders would face if the firm
had no debts (Brigham & Ehrhardt, 2019). Business risk, which is considered
essential to operations, is dependent on many factors including market volatility,
sales price, cost of goods, and operating leverage. When a small change in sales
results in a large change in earnings, the firm is said to have high operating
leverage.
Financial risk is the additional risk common stock holders take as a result of
decisions to finance with debt (Brigham & Ehrhardt, 2019). Financial risk factors
include the following:
● interest rates - the amount charged by a lender for the use of their money.
● percentage of debt financing - the amount of financing necessary to raise
funds for working capital/expenditures.
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, ● debt and equity ratio - measures the percentage of debt and equity
financed and foreign currency exchange
When evaluating the business risk for Moore’s Plumbing Supply there are a
couple factors to consider. Due to the life experience of Stan, operations are
primarily funded with short term debt and the Moore family currently holds 75
percent of all outstanding debt. While family businesses are not always a bad
thing, financing in this manner could cause issues down the road. Tom must
decide if he will continue under this capital structure or if he will adjust the
thresholds for debt and equity. While the foundation for the business is solid, he
may choose increase the long-term debt threshold in order to grow the business.
b. How do these risks relate to total risk?
Total risk is the combination of financial and business risk. Business risk is a major factor
in determining total risk. Some investors or evaluators may not agree with the family
owned debt and want to see the company increase the threshold for debt in other ways.
c. How does business risk affect capital structure decisions?
Business risk helps to determine capital structure decisions. As previously mentioned,
threshold for debt and equity must be established in order to make capital structure
decisions. These thresholds and amounts will determine the business risk of the company
itself.
3. Discuss the following issues relating to Modigliani and Miller’s (MM) 1958 capital structure
model.
a. What was the importance of the model?
Modigliani and Miller’s (MM) model while unrealistic in practice, led to the
determination of the factors that are relevant to capital structure and a firm’s value. Their
work also led to the development of options and derivatives (Brigham & Ehrhardt, 2019).
b. What are the basic assumptions of the model?
MM’s capital structure theory implies that more debt in capital structure will not lead to
increased overall value in the firm. (Brigham & Ehrhardt, 2019). This is due to the
benefits of cheaper debt being offset by the increase in the riskiness of the equity.
Ultimately, the theory states in a world without taxes, both the value of a company and its
WACC are unaffected by capital structure (Brigham & Ehrhardt, 2019). The model
assumed:
no brokerage costs
no taxes
This study source was downloaded by 100000804831080 from CourseHero.com on 04-10-2022 15:13:34 GMT -05:00
https://www.coursehero.com/file/66356519/Unit-5-Assignmentdocx/
Unit 5 Assignment
Problems:
1. What is meant by capitalization? What is meant by a firm’s capital structure? For
financial planning purposes, explain why either book or market value should be used to
determine the firm’s capital structure. What is capital structure theory?
Capitalization is the process of evaluation and maximizing a company’s capital
structure i.e. debts and equities. Capital Structure is a firm’s combination of deb
and equity. Capital structure is used to determine the thresholds for debt and
equity a company is willing to accept.
While both book value and market value offer meaningful information, they are
used in different scenarios in business. For financial planning purposes, market
value is best. Investors in business often rely on the market value rather than book
value when evaluating a company (Seth, 2010)
According to Brigham & Ehrhardt (2019) capital structure theory states in a world
with no taxes, the value of a firm and its WACC are unaffected by its capital
structure.
2. Discuss the following issues relating to business risk and financial risk.
a. What is the difference between business risk and financial risk? Explain some of the factors
that contribute to each. Evaluate Moore Plumbing Supply’s level of business risk.
Business risk is the risk a company’s common stock holders would face if the firm
had no debts (Brigham & Ehrhardt, 2019). Business risk, which is considered
essential to operations, is dependent on many factors including market volatility,
sales price, cost of goods, and operating leverage. When a small change in sales
results in a large change in earnings, the firm is said to have high operating
leverage.
Financial risk is the additional risk common stock holders take as a result of
decisions to finance with debt (Brigham & Ehrhardt, 2019). Financial risk factors
include the following:
● interest rates - the amount charged by a lender for the use of their money.
● percentage of debt financing - the amount of financing necessary to raise
funds for working capital/expenditures.
This study source was downloaded by 100000804831080 from CourseHero.com on 04-10-2022 15:13:34 GMT -05:00
https://www.coursehero.com/file/66356519/Unit-5-Assignmentdocx/
, ● debt and equity ratio - measures the percentage of debt and equity
financed and foreign currency exchange
When evaluating the business risk for Moore’s Plumbing Supply there are a
couple factors to consider. Due to the life experience of Stan, operations are
primarily funded with short term debt and the Moore family currently holds 75
percent of all outstanding debt. While family businesses are not always a bad
thing, financing in this manner could cause issues down the road. Tom must
decide if he will continue under this capital structure or if he will adjust the
thresholds for debt and equity. While the foundation for the business is solid, he
may choose increase the long-term debt threshold in order to grow the business.
b. How do these risks relate to total risk?
Total risk is the combination of financial and business risk. Business risk is a major factor
in determining total risk. Some investors or evaluators may not agree with the family
owned debt and want to see the company increase the threshold for debt in other ways.
c. How does business risk affect capital structure decisions?
Business risk helps to determine capital structure decisions. As previously mentioned,
threshold for debt and equity must be established in order to make capital structure
decisions. These thresholds and amounts will determine the business risk of the company
itself.
3. Discuss the following issues relating to Modigliani and Miller’s (MM) 1958 capital structure
model.
a. What was the importance of the model?
Modigliani and Miller’s (MM) model while unrealistic in practice, led to the
determination of the factors that are relevant to capital structure and a firm’s value. Their
work also led to the development of options and derivatives (Brigham & Ehrhardt, 2019).
b. What are the basic assumptions of the model?
MM’s capital structure theory implies that more debt in capital structure will not lead to
increased overall value in the firm. (Brigham & Ehrhardt, 2019). This is due to the
benefits of cheaper debt being offset by the increase in the riskiness of the equity.
Ultimately, the theory states in a world without taxes, both the value of a company and its
WACC are unaffected by capital structure (Brigham & Ehrhardt, 2019). The model
assumed:
no brokerage costs
no taxes
This study source was downloaded by 100000804831080 from CourseHero.com on 04-10-2022 15:13:34 GMT -05:00
https://www.coursehero.com/file/66356519/Unit-5-Assignmentdocx/
