The text indicates that small cap growth stocks have performed better over time

Question

The text indicates that small cap growth stocks have performed better over time in terms of total return. However this higher return is related to higher risk because during a market’s high growth phase many firms get shaken out of the market. Once the market matures the situation changes. Please explain the following relationships between a firm and its market stages of growth, the kind of financing it should be seeking, the providers of such external finance at each stage of a market’s development, the appropriate mix of debt to equity and how this can vary by industry.

In a capital intensive but mature industry such as an electric utility growing about 5% per year on average and facing steady demand what would be the appropriate financing to add a gas turbine costing $300 million? Where would the utility seek financing?

Explanation / Answer

The Operating Income Approach: In this approach, the optimal debt for a firm is chosen to ensure that the probability that the firm will default does not exceed a management-specified limit.

The Cost of Capital Approach: In this approach, the optimal debt ratio is chosen to minimize cost of capital, if operating cash flows are unaffected by financing mix, or to maximize firm value.

The Adjusted Present Value Approach: In this approach, the effect of adding debt to firm value is evaluated by measuring both the tax benefits and the bankruptcy costs.

The Return Differential Approach: In this approach, the debt ratio is chosen to maximize the difference between ROE and cost of equity.

Comparable Approach: The debt ratio is chosen by looking at how comparable firms are funded.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.