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Why or why not A bondholder is the lender to the firm whereas a shareholder is the owner of the firm. The shareholder has a primary right over firms earnings while a bondholder has control over firms operational decisions that affect cash flow and firms risk scenario. Firm choose to optimal leverage after a comparison of the losses and the gain with debt or equity corporate tax may offer a debt tax shield owing to the deductibility of interest and incentive to increase Debt.
The degree of business risk of a firm depends on the degree of operating leverage production of fixed cost. Financial distress may ultimate force a company to insolvency. Agency cost it may conflict of interest share holders and debt holder and management these conflict give rise to agency problem, which involve agency costs. Agency cost have their influence on a firm capital structure. Share holder debt-holder conflict Share holder management conflict Monitoring and agency cost.
Levered Firm: A Firm that finance its assets by equity and debt is called a Levered firm. Unlevered Firm: A firm that that uses no debt and finances its assets entirely by equity is called unlevered firm.
Financial Leverage affect the value of firm when personal tax and corporate are considered. After-Tax income of the firm will be reduced when the personal rate of lenders is higher than personal rate of shareholders. The value of the firm will increase with debt due to the deductibility of interest charges for tax computation, and the value of the levered firm will be higher than of the unlevered firm.
Cash Flows: Cash flows are after the corporate and personal tax ,the appropriate discount rate will be pure-equity capitalization rate adjusted for personal taxes. The capital structure will be planed initially when a Company is incorporated. A constant level of EBIT- constant business risk- is assumed in order to isolate the impact on returns of the financing costs associated with alternative capital structures EBIT-EPS analysis tends to concentrate on the maximization of earnings rather than shareholders wealth and ignores risk.
This method involves the comparison of alternative methods of financing under various assumptions as to EBIT. Hence debt is a cheaper source of funds than equity. But debt causes financial risk, which increases the cost of equity. Higher debt increases the costs of financial distress and the agency costs also increase.
The tax deducibility of interest charges, however, adds value to shareholders. Thus, there is a trade-off between the tax benefits and the costs of financial distress and agency problems. A sound capital structure is expected to be conservative. Conservatism does not mean employing no debt or small amount of debt. Conservatism is related to the firms ability togenerate cash to meet the fixed charges created by the use of debt in the capital structure under adverse conditions.
The capital structure of Blaine is prudent and conservative. There are only two borrows in history. The main source of funding for business comes from equity capital. Reinvestment Threat- If the company has a lot of surplus cash there will be big risk of capital misallocation. The Mgmt. In addition, the company can deduct the interest paid on the debt from their income and thus reduce the tax burden. With an increase of future corporate tax from Debt greatly reduces the role of integrated enterprise cost of capital Therefore, it can increase earnings per share and its stock value by improving the proportion of corporate debt appropriately, which assumes a crucial role of financial leverage Q.
What are primary advantages and disadvantages of such a move? Dubinski should recommend a large share repurchase to the board using cash and cash equivalents and raising some debt. Debt is a lower cost source of funds and allows a higher return to the equity investors by leveraging their money. Assuming that family members held on to their shares, their percentage ownership of Blaine would rise, reversing a downward trend dating from BKIs IPO.
It also would give the board more flexibility in setting future dividends per share. The company will have a better Return on Equity. Since, debt is being raised the WACC will come down as a cost of equity decreases b the contribution of cost of equity to WACC decreases with cost of debt being included; which is usually less than COE due to tax benefits. Disadvantage High Price Market Signaling Loss of investment income-The interest that could have been earned from investment of surplus cash is lost.
How should such a buyback affect Blaine?
Blaine Kitchenware, Inc.: Capital Structure
Anonymous Text preview of this essay: This page of the essay has words. Download the full version above. Why or why not? Capital structure: Blaine has an unlevered capital structure currently i.
Blain Kitchenware CF Case