1) In addition to the tax shield offered by governments around the world, debt h

Question

1) In addition to the tax shield offered by governments around the world, debt has a lower required rate of return than equity - explain why this is so? 2) Given the inherent tax shield advantages why might we still come across 100% Equity financed firms? 3) Why is it not common to see firms with extremely large debt components in their capital structure? 4) Is there an optimal ratio of debt to equity and if so what factors determine it? 5) Why is it not appropriate to evaluate all potential projects based on a firms WACC?

Explanation / Answer

1) Debt has a lower required rate of return than equity :

This happens because of several reasons which is as follows:

(a) Debt is issued with the securities against assets or issued with collateral securities ,which results in less of loss risk, due to which company provide less return

   (b) Dividend payment to Equityholder is uncertain and not fixed, while interest payment to Debtholder is fixed and payment of interest is made prior to Equityholder's Dividend

   (c) Company liability against Debtholder is paid off first at time of Liquidation of Company, then remaining amount left after paying off Debt is distributed to Equityholders.

(d) Expenses are incurred in raising the Equity are much as compared to raising the Debt by company.

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