A utility company is allowed to charge prices high enough to cover all costs, in

Question

A utility company is allowed to charge prices high enough to cover all costs, including its cost of capital. Public service commissions are supposed to take actions to stimulate companies to operate as efficiently as possible in order to keep costs, hence prices, as low as possible. Some time ago, AT&T's debt ratio was about 33 percent. Some people argued that a higher debt ratio would lower AT&T's cost of capital and permit it to charge lower rates for telephone service. Gordon thought an optimal debt ratio for AT&T was about 50 percent. Do financial theories support or refute this position? Explain.

Explanation / Answer

Myron Gordon is a proponent in the belief that shareholders are averse to risk and have strong preference to receive dividend payments rather than future capital gains.He believed that the payment of current dividend resolves uncertainty with the investors which makes this quite perplexing becaouse he thinks that AT & T could go up to 50% debt ratio.So,If we look at AT & T wanting to increase their debt ratio it would not be good for the investors that want to keep the status quo but if it lowers the cost of phone service to the consumers it may equal out.However, with the MM ideology , AT & T increasing their debt ratio to 50% ,the investors shold not like it because it is a financial risk ,company should not be capable of repaying the debt and the optimal leverage occurs when the marginal benefit of debt equals the marginal cost of debt.

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