Financial management, firm value, and capital structure Harvard Case Solution & Analysis

Financial management, firm value, and capital structure Case Solution

Agency cost theory

Agency cost theory implies that the capital structure of the company is determinable through costs of debt and equity issue. Through debt issue the company can get the opportunity to get funds and invest in risky projects but that yield high returns whereas, the debt holders might require high premium.After knowing the company’s intention to invest in riskier project,this will increase the costs of debt.It would increase the equity and debt both due to the agency’s costs, therefore there should be balance between theses both costs to have an optimal debt-equity ratio. There may be conflicts occur between the owners and the management of the company due to agency cost. (Niu, march 2008)

For firm z if it issues debt, then that would incur agency cost. This agency cost might also include the firm’s investment decision. Different conflicts might arise between the shareholders (investors) and the management of the company. As investment advisor the investors should consider the intention of the company firstly in order to identify the purpose of the company for taking the debt. If the investment project does not contribute to the invested amount value and shareholders’ interest of firm’s value maximization then the investors should go against the debt issue decision. If the investment project maximizes the value such as if invested in riskier project and yielding high return, then this will cause an increase in dividend payment for investors. This debt issue is in favor of investors.Some agency cost might incur here between bondholders and investors in which the investors will require investment in more risky projects to have more dividend payment whereas, with more risk the bondholders require more premium and interest. Bondholders might also anticipate the failure of firm to pay off the debt. For resolving conflicts contractual agreement might limit the dividend payments so that the firm has enough cash to pay out its obligations.

Static Trade-Off Theory

In the static trade-off theory it suggests that the debt issue might be to get trade-off between interest tax shield and financial distress cost. As an investment advisor, this debt issue might be the firm’s efforts to get advantage of tax shield, which could be gained and as a result, its financial position could improve with lower interest to pay on debts. The firm has lower debt issue as compared to equity therefore;the management might seek balance in the debt-equity ratio. The debt issue, in this regard, is a better decision and should be praised. (Eckbo, 2008)....................

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