University of the Cumberlands Capital Structure & Dividend Pay Outs Questions

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CAPITAL STRUCTURE AND DIVIDEND PAYOUTS

The board of directors of Baldwin Inc. met today to discuss the capital structure and dividend policy of the company. The board discussed the optimal capital structure of 60 percent debt and 40 percent equity and the likely effect of the capital structure on the company’s weighted average cost of capital (WACC) and the firm value. During the meeting it came up that debt provides tax benefits to the firm because interest is tax deductible whereas dividend is not. Therefore, the debt ratio of 60 percent was considered acceptable. However, Gregg, the CFO of the company, stressed that debt can put pressure on the firm because interests and principal payments are fixed obligations that the company must pay, no matter the profit of the company. He stated that if these obligations are not met, the company may risk some sort of financial distress and files for bankruptcy. Gregg continued to explain that if the company files for bankruptcy there are direct and indirect costs that Baldwin must incur.

Mr. Milosvoski, a board member suggested that there are ways to reduce the cost of debt by hiring an expert to handle the company’s debt agreements between the shareholders and bondholders. He stated that protective covenants are incorporated as part of the loan agreement and must be taken seriously because a broken covenant can lead to default. He mentioned negative covenant and a positive covenant as types of protective covenants the company should take seriously.

John Miller, another board member stated that one reason bankruptcy costs are so high is that different creditors and their lawyers contend with each other. He suggested that if debt can be consolidated, or if bondholders can be allowed to purchase stock of the company bankruptcy cost will be reduced. In this way, stockholders and debtholders are not pitted against each other because they are not separate entities. He cited examples in Japan where large banks generally take significant stock positions in the firms to which they lend money.

The employee representative on the board, Ms. Johnson used the free cash flow hypothesis to state that firms with high free cash flow are very likely to undertake more wasteful activity which has a serious implication for capital structure. Since dividends leave the firm, they reduce free cash flow. Thus, according to her, an increase in dividends should benefit the stockholders by reducing the ability of corporate managers to pursue wasteful activities. She continued that since interest and principal also leave the firm, debt can reduce free cash flow and wasteful spending. But because corporate managers are not legally obligated to pay dividends, she suggested that debt of the company be increased.

Philip Suzuki, director of Public Relations and a board member was of the view that determining optimal debt-equity ratio is not an easy task and varies across industries so Baldwin should follow the rules of the pecking-order theory when financing capital projects. No agreement was reached on the company’s capital structure, but the CEO and Gregg believed that the 60-40 debt-equity capital structure will minimize the cost of capital and improve the firm value.

The board is retaining you as the financial consultant to assist with the company’s capital structure and dividend payout decisions. The Chairman of the board wants you to address the following questions:

  1. List 5 reasons to support Ms. Johnson’s free cash flow hypothesis claim that debt of Baldwin Inc. be increased. The reasons you give should focus on advantages of debt that can convince the board to increase the debt-to equity ratio of the company.
  2. State 5 examples of direct and indirect costs associated with bankruptcy that Gregg stated in his presentation to the board.
  3. Give two examples each of positive covenant and negative covenant as stated by Mr. Milosvoski in his protective covenant explanation.
  4. Explain the rules of pecking-order theory of capital structure as suggested to the board members by Mr. Suzuki, the director of Public Relations.
  5. Do you agree with Ms. Johnson’s statement that an increase in dividend is beneficial to the stockholders of Baldwin? Explain with three reasons why or why not.
  6. Baldwin Inc. is planning to pay dividends of $3 per share to shareholders in 2020 (total dividend is $3 million). But because of personal taxes on dividend income, the company wants to postpone the dividend to next 5 years when they believe a new tax legislation will be passed by Congress to give tax exemption on dividend and investment income. Suggest three alternatives to the board of how the available cash can be used in place of the dividend.
  7. Baldwin Inc. wants you to help them prepare a dividend policy which will guide the first dividend payout of the company in 2025. List five characteristics of a sensible dividend policy you want the board to know.

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Running head: CAPITAL STRUCTURE AND DIVIDEND PAYOUTS

Assignment 6: Capital Structure and Dividend Payouts.
Student’s Name
Institution
Date

1

CAPITAL STRUCTURE AND DIVIDEND PAYOUTS

2

Capital Structure and Dividend Payouts
Question 1.
There are two kinds of financing activities, to begin with, is equity finance, whereby the
organization issue offers to the general population, consequently they will get proprietorship
for the organization. Subsequently, the organization takes debt by giving bonds or taking an
advance from the bank, and consequently, they pay interest on that debt.
The following are 5 reasons that back Ms. Johnson’s free cash flow hypothesis speculation
that asserts that debt ought to be expanded by the organization
a. Proprietorship for the firm will be held: When an organization issues debt they needn't
bother with any proprietorship or casting ballot rights. Debt financing aids in holding
control on business and there is no weakening of proprietorship.
b. Deductible tax: In debt financing, the organization needs to pay interest on the debt
that was acquired by the firm. That interest is tax-deductible and saves the tax as it is
deducted from the income before paying taxes. It also improves the cost of debt of the
company and lowers its effect because it is tax-deductible.
c. Enhances management and present administration can be held: Debt financing is a
costly cycle when contrasted with equity finance since giving of share includes
administrative bodies that make this process intricate. Just as voting power will be
held to the current administration. There is the dissemination of profit among current
adm...


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