The Trade-Off Theory of Capital Structure
A noncallable bond will fetch a high price than a callable bond as it is deemed more stable by an investor. On the other hand, callable bonds are more risky to the issuer and hence they must compensate the high risks with high coupon rate.
Every bond is rated by at least a rating institution, and the rating gives investors critical information about a bond, its issuer and allows to make an informed decision when deciding whether to buy a bond or otherwise. These ratings have become a fundamental tools that investors rely on the appraising the quality of a bond. According to Pacific Daily news (2014), the recent GPA successfully sold $76. 47 million of revenue bonds
The trade-off theory of capital structure is the notion that a company decides on the level of debt finance and equity finance to be used in controlling the costs and benefits.
The concept of dividend signaling asserts that the announcement of dividend payments by a company contributes positively to the future prospects of the company. The announcement of a rise in dividend payout helps to solidify the prospects in the market and improves the image of the company in lieu of growth prospects and stability in the future.
How much will a firm receive in net funding from a firm commitment underwriting of 250, 000 shares priced to the public at $40 if a 10% underwriting spread has been added to the price paid by the underwriter? Additionally, the firm pays $600, 000 in legal fees
250, 000X40 = 10, 000, 000
Underwriting fee = 0. 1X10, 000, 000
= 1, 000, 000
Legal fees +600, 000
1, 600, 000
The net amount the firm will receive will be 10, 000, 000-1, 600, 000
= 8, 400, 000
Shares 1million X $23
Underwriter’s spread $1. 90/share, and the total underwriter spread $1. 9 million
Legal and other fees $1. 65 million
Share price on the issue day $27. 50
According to Baker (2005), underwriter spread fall in the category of direct expenses whilst management fees such as legal feels fall with the indirect issuance expenses. Hence, $1. 9 million becomes the direct expenses and $1. 65 million become the indirect expense for the issuer.
The total costs of issuance becomes
Underwriting expenses 1, 900 000
+ Legal fees 1, 650 000
3, 550 000
Percentage of the market value of the shares represented by the costs = total costs/total value of shares
3, 550, 000/23, 000, 000
ABC outstanding shares 10, 000 sell at $20
Operating income $30, 000
Intent issue of $50, 000 in 8% debt
Value of the firm
In economics, the value of the firm is linked to profit maximization; as a result the value of the firm is the present value of the firm’s current and future profits. In finance to determine the present value of a firm, the present income is multiplied by five. Hence, the present value of ABC is operating incomeX5
$30, 000 X5 = $150, 000.
Earnings per Share (EPS) is calculated by subtracting dividends from preferred stock from net income and then dividing the result by the average outstanding shares
EPS = income/outstanding shares
30, 000/ 200, 000
= 0. 15
Rate of return on the stock before restructuring
Rate of return on stoke before restructuring = returns/ value of shares
30, 000/200, 000
Rate of return on the stock after restructuring
30, 000/250, 000
The converted debt increased share holder value for the same rate of return, and hence mathematically if the value of a denominator increases in lieu of a constant numerator, then the result must be lower.
How investment in DEF will change if you currently own 100 shares valued at $10 each and DEF has declared a 10% stock dividend? Before the stock dividend there were 2000 shares outstanding.
Total value of own shares at DEF = $1000
A 10% dividend payout will imply a dividend income of $100
Before dividend payout, DEF had 2000 shares outstanding
Baker, H. K., & Powell, G. E. (2005). Understanding financial management: A practical guide. Malden, MA: Blackwell Pub.
Pacific Daily news. (2014). UPDATE: GPA sells bond. Guampdn. com. 17th September 2014. http://www. guampdn. com/article/20140918/NEWS01/140918003/UPDATE-GPA-sells-bond
The trade-off theory of capital structure
The Trade-Off Theory of Capital Structure