Question

Asked Oct 31, 2019

You are a management trainee in one of the Manufacturing companies based in Johor, Malaysia. The company was established in 2003 and recently has been listed in Bursa Malaysia. Currently, the debt-equity ratio of the company is 0.30. Your CFO's role demands him to maximize the value of the firm. Your CFO asked you that is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not? He gave you a couple of days to answer this question. You need to support your answers with examples.

Step 1

The future cash flows and the discount rate are the two factors on which the value of the firm relies. Weighted average cost of capital is used to calculate discount rate for more appropriate results.

Step 2

Given:

Debt-equity ratio is 0.30

Known facts:

The ideal debt-equity ratio is 1:1.

Generally, cost of debt is less than the cost of equity.

Leverage increases when the debt of the firm increases which initially boost the value of the firm up.

Step 3

Management needs to reach an appropriate level of leverage by increasing the debt. This increase in debt will reduces the weighted average cost of capital (to a certain level) and increases the value of the firm. But at the same time, the more debt means more risk. Excess debt in the firm may increase the risk that cannot be mitigated. The leverage can reduce the cost of capital to a certain level only, after which it starts increasing.

In the ever-changing environment, it is very difficult to obtain such leverage ratio where firm’s value can be maximized by minimizing ...

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