Finance Assignment

4181 words - 17 pages

JOURNAL OF ECONOMICS AND FINANCE EDUCATION  Volume 9  Number 2  Winter 2010

29

Using Microsoft Corporation to Demonstrate the Optimal Capital Structure Trade-off Theory
John C. Gardner, Carl B. McGowan Jr., and Susan E. Moeller1 ABSTRACT
In this paper, we apply the trade-off theory of capital structure to Microsoft. We use data for bond ratings, bond risk premiums, and levered CAPM betas to compute the cost of equity and the weighted average cost of capital for Microsoft at different debt levels. This study shows the impact of increasing financial leverage on WACC. As financial leverage increases, the WACC decreases until the optimal debt ratio is reached, after which, the WACC ...view middle of the document...

Although a firm’s costs of debt and equity at first increase as it raises the proportion of debt in its capital structure, the overall WACC will decrease over this initial range as the tax benefit outweighs the negative impact of the increases in the component costs of the WACC. At a certain level of financial leverage, however, the tax benefit will no longer provide a sufficient advantage to overcome the rising costs of debt and equity. Past a certain debt ratio, the market will demand a yet higher interest rate and cost of equity as the market perceives that the firm’s risk of bankruptcy is increasing because of the firm’s rising debt load. Consequently, after this point of financial leverage, the firm’s WACC begins to increase. At the point where a firm’s WACC is minimized, the firm’s value is maximized, a relationship which can be demonstrated using simple algebra. In this study, we provide an empirical demonstration of the trade-off theory of financial leverage using Microsoft Corporation, a company that has had no long-term debt in its capital structure since its inception thirty years ago (the capital structure is 100 percent equity)2. We show how, in principle, Microsoft Corporation could maximize the firm’s value by increasing its financial leverage. Application of the theory involves calculating the firm’s weighted average cost of capital under different financial leverage scenarios using actual market information to determine Microsoft’s costs of debt and equity as financial leverage increases.

1

The authors are faculty at University of New Orleans, Norfolk State University, and Eastern Michigan University, respectively. The authors would like to thank the reviewers and editor for helpful comments while retaining responsibility for any errors. 2 For an empirical explanation of why companies choose to be debt free see Gardner and Trzcinka (1992).

JOURNAL OF ECONOMICS AND FINANCE EDUCATION  Volume 9  Number 2  Winter 2010

30

The next section illustrates how the WACC of Microsoft can be calculated and used in conjunction with the trade-off theory to determine its optimal capital structure. To maximize its market value, Microsoft would continue to increase its debt ratio until the WACC is minimized.

Calculating the Optimal Capital Structure for Microsoft Corporation
Determining the Cost of Debt as Financial Leverage Increases
Assuming that the bond market is efficient in determining the risk of a firm’s debt allows the use of the yield to maturity of a firm’s new bond issues as a proxy for a firm’s cost of debt. Of course, the firm’s debt ratio is not the only factor that changes as a firm’s bond rating decreases. The models used by bond rating agencies are more complex and include numerous factors, all of which deteriorate as the riskiness of the firm increases. We use the debt ratio alone as a proxy for these various effects. Table 1 is derived from S&P (2006) and Damodaran (2008) and shows the average debt ratio...

Other Papers Like Finance Assignment

Diploma Finance Hots Self-Evaluation Report

572 words - 3 pages Diploma Finance HOTS Self-Evaluation Report For: Mr Coy Module: Hospitality Finance 2 Student Name: Nick Le HOTS Team Name: N2A Date: 14th, May, 2012 Abstract. The assignment is self-evaluation report which assesses and analyse individual performance after running HOTs program. Besides that, this report also show the discuss about personal strengths and weaknesses and given the recommendations on how to improve

The One Essay

345 words - 2 pages UNIVERSITI TUNKU ABDUL RAHMAN (UTAR) FACULTY OF BUSINESS AND FINANCE (FBF) MAY 2012 TRIMESTER UBMM/UKMM1013 MANAGEMENT PRINCIPLES TUTORIAL QUESTIONS Bachelor of Business Administration (Hons) (BA) Bachelor of Commerce (Hons) Accounting (AC) Bachelor of Business Administration (Hons) Banking & Finance (BF) Bachelor of Economics (Hons) Financial Economics (FE) Bachelor of Arts (Hons) English Language

Module Fin301 Description Only

418 words - 2 pages  yourself that you would like to share with the  class so that we can get to know you better. ● ● ● ● ● Your reasons for taking this course Your professional experience and interest in finance as a profession Your background in general Your experience with online learning Your expectations from this course Note: The Introductions Forum is not graded but required. Written Assignment 1 Complete the following chapter problem set

Acc 544 (Internal Control Systems )Complete Class Week 1-5 Includes All Dqs, Individual And Team Assignments

465 words - 2 pages ? Explain the details of a fraud scheme that internal controls cannot impede because of inherent limitations. ACC 544 Week 5 Controls for Outflows Learning Team Assignment: Controls for Outflows Design a proposal for appropriate controls to cover purchasing, accounts payable, cash disbursements, finance, investment, and payroll. Include at least 3 references in your paper. Discussion Questions Explain some risks inherent in the acquisition and

Orgb

677 words - 3 pages Assignment 1 Assignment Instructions Complete this assignment after you have finished Lessons 1, 2, 3, and 4. It is worth 20 percent of your final mark. Review the Sample Assignment page (see the Evaluation block on the course home page) before beginning work on this assignment. It contains information that will help you maximize your mark on this assignment, including how to use APA style. Part A Part A consists of three

Hca 250 Financial Concepts

275 words - 2 pages Associate Level Material Financial Concepts and Reports Consult Ch. 1 & 2 and the glossary of Health Care Finance as well as other outside sources as necessary to complete the assignment form below. Part 1: For each term in Column A, select the correct definition from Column B on the right. Write the corresponding letter of the definition next to the term. |Column B – Definitions

Business Environment

584 words - 3 pages | |Assessor: | | Unit 1 The Business Environment |Assignment Deadlines | |Assignment Deadline Date: |Hand out

Unv 103 Topic 1 Navigating Loud Cloud And Time Management

4008 words - 17 pages Name: Julie Portillos Course: UNV103 Date: 12/30/2014 Instructor: Justin Johnson ------------------------------------------------- Topic 1 Assignment: Navigating Loud Cloud & Time Management Purpose of Assignment: To become familiar with the GCU Learning Management System (LMS) Loud Cloud and the GCU website, and to also help you develop time management, an important skill for college and everyday life. This assignment will be in two

Case Study

1088 words - 5 pages counts are an integral part of the assignment, and assignments exceeding the word count will be penalised. Assignments should be double-spaced, in Times New Roman 12 font, with the word count for each section clearly displayed. 3. Further guidance on how to approach the case study will be available from the case study lecture – lecture 6 (April 8). Reference to the UQBS Writing Guide (2010), a copy of which is available under Case Study

515fin Homework Wk1

921 words - 4 pages individual assets and portfolios of assets. G Given a company's financial statements and sales forecast, develop a monthly cash budget for at least one year and pro forma financial statements for five years. Utilizing financial ratios and other analytical techniques, evaluate the company's strengths and weaknesses and its long-term financial requirements. Homework Assignment Complete the following graded homework assignment in a Word document

Termpaper

4908 words - 20 pages Government on all financial matters, including Budget preparation, Grant distribution and Revenue Mobilization. Specifically, LGFD is responsible for: * designing a fiscal decentralization strategy, including revenue assignment and the design of an inter-governmental transfer system, using a formula-based grants distribution system; * advise the Local Government Finance Committee, based on analyses of local revenue generation capacity and

Related Essays

Finance Assignment

1461 words - 6 pages Assignment 1 Economics for Management – GSB728 Due on: 07/06/2010 University of New England Victor M. Ayala Lancheros Student # 220070594 Word Count: 1,152 Economics for Management – GSB728 PART 1 Question # 1 Demand for Bus Services: D1 = 3,500 – 350P1 + 25P2 + 2Y Supply for Bus Services: S1 = 100P1 The market equilibrium point is obtained where S1 = D1 therefore, 100P1 = 3,500 – 350P1 + 25P2 + 2Y Substituting for Price of Taxi trips (P2

Banking And Finance Assignment Package 2 (Weight In Total Marks 20% ) Each Of The Following Question Carries 2 Marks

271 words - 2 pages Q1. What is risk premium? How is it measured? When there is an increase in the default risk on corporate bonds (due to bad economic conditions), what will happen to risk premium. Will it shrink or widen? Why? (See pages 120-22 3rd edition) (see page 114-115 4th edition) Default risk occurs when the issuer of a bond is unable or unwilling to make interest payments when promised or pay off the face value when bond matures. This could happen to

Gbm 381 Week 5 Individual Assignment

371 words - 2 pages This pack of GBM 381 Week 3 Individual Assignment Chapter 10, 15, includes: Chapter 10 1. Indicate how each of the following international transactions is entered into the U.S. balance of payments with double-entry bookkeeping: (a) A U.S. resident imports $500 worth of merchandise from a U.K. resident and agrees to pay in three months. (b) After the three months, the U.S. resident pays for his imports by drawing down his bank balances in

Five Competitive Forces That Shape Strategy

835 words - 4 pages FACULTY OF ACCOUNTANCY, FINANCE AND BUSINESS Coursework: BBMF3023 Corporate Treasury Management Programme: Bachelor of Business (Honours) Accounting and Finance Academic Year: 2016/2017 Group coursework Corporations must strike a balance between current dividends and future growth which maximise the price of stock. Discuss the corporate dividend policy. You are required to include a public company listed in Bursa Malaysia and