Daktronics' Capital Structure Policy
Worksheet 5:
Current Debt-Equity Policy of the company:
Referring to the financial statements of the company, we came to know that since the company has not acquired any debt financing in its capital structure, the debt equity ratio has been zero(0) since 2010. Thus, although the company is trading without any financial risk, but since it is not using the available debt resources, it is letting go the advantages offered by debt financing in the form of tax shield. Thus, the treasurer should consider including debt financing as it will only add value to the company because of tax shield offered by debt financing.
Implications of various financial theories
i) MM Proposition(With taxes)
As per this theory, since, the tax code of most of the countries allows interest expense to be claimed as an expense and also because dividends are paid on an after-tax basis, including debt will enhance the value of the firm. In other words, The differential tax treatment encourages the firm to use debt financing because debt provides the tax shield that adds value to the firm.
Tax Shield= Amount of debt*Marginal Tax Rate
Implication:
As per this theory, the value of Daktronic’s will be maximized at 100% debt and its WACC will keep on reducing as it includes more and more debt in the capital structure.
ii)Static Trade Off Theory:
The static trade off theory seeks to balance the cost of financial distress with the tax shield benefits from using the debt. Under the static trade off theory, there is an optimal capital structure that has an optimal proportion of debt.
Implication:
If the treasurers of Daktronic company will follow static trade off theory, they fully understand that there are tax benefits associated with debt issue as interest expense is tax deductible. However, at the same point, they shall also be concerned with the increase in cost of financial distress following increase in the use of debt. At some point, the costs of financial distress will exceed the tax benefits of debt. Thus, following the static trade off theory they will seek to balance the benefits of debt with the costs of financial distress and identify an optimal structure.
iii)Pecking order theory:
A s per Pecking Order Theory, the managers of the company prefers to make financing choices that are least likely to send the signals to the investors and they follow a hierarchy for financing, with retained earnings being the most preferred source of finance, debt being the next best choice and external equity being the lease preferred financing option:
Implication:
In contrast to trade off theory, firms following pecking order theory does not follow a target amount f debt equity combination. Rather, each firm decides its capital structure based on individual financing needs. Here, every firm will finance its project using the retained earnings and only when it needs additional funds it will go for debt financing. However, at some point, when the leverage facility is fully exhausted, they will give way to equity issuance. Thus, the amount of leverage is determined by the happenstance of available projects and not by pre-determined optimal debt-equity ratios.
Advantages of Debt Financing:
Tax Shield and Value Addition:
Inclusion of debt in the capital structure of the company will allow Dektronics to charge the interest payment as a pre-tax expense. This will lead to lower bottom line profits for the firm and an equivalent tax shield and value addition to the firm.
Disadvantages of Debt Financing
Financial Distress:
In general, high amount of debt results in higher probability of the financial distress. Although, the debt offers benefits in the form of tax shields but at the same time, the company might face financial distress when the earnings decline and it start facing losses. Thus, if the company fails to pay of its interest or principal obligation, it might also face bankruptcy risk.
Question 6:
How Vulnerable is the company for takeover:
Previous researches has shown that the firms with unused debt capacity are more vulnerable to takeovers. In other words, an unlevered firm as Dektronics is more likely to be takenover by over-levered firm. Since, the buyer of the company is aware of the unused debt capacity of the firm, he find it convenient to take-over the targeted company by financing the takeover by the target firm’s unused debt capacity. As a result, Dektronics, which has excess debt capacity available with it, is on high risk of being taken over
However, apart from current debt levels in the company, there are other factors that might affect takeover efforts towards the company:
1)Takeover laws:
Takeover laws at state or federal levels and amendments in the corporate charter designed specifically to prevent hostile acquisitions.
2)Inside Holding by managers:
The extent of holding in the company by the managers and insiders also determines the level of takeover threat.
3)Recent Stock Performance:
Stockholders in firms where stock prices have dropped significantly over time tend to be much more receptive to the entreaties of hostile acquirers.
