FIN4801 ASSIGNMENT 5
2024
SEMESTER 2
2024
, QUESTION 1
a.) Capital Structure and Risk/Return
Changing a company's capital structure directly impacts its risk profile and expected
return.
Increased Debt (Higher Leverage)- Higher debt levels increase financial risk. This
means
Higher Interest Expense-This reduces profits, making the company more
vulnerable to economic downturns.
Increased Default Risk- A higher debt burden makes it harder to meet
obligations, potentially leading to bankruptcy.
Higher Expected Return- Investors demand a higher return to compensate for
the increased risk.
Decreased Debt (Lower Leverage)- Lower debt levels decrease financial risk,
leading to
Lower Interest Expense- This improves profitability and makes the company
more stable.
Reduced Default Risk- A lower debt burden makes it easier to meet
obligations, reducing the risk of bankruptcy.
Lower Expected Return- Investors require a lower return due to the reduced
risk.
b.) Capital Structure Theories
The case of Offices Ltd. reflects a combination of capital structure theories
Trade-off Theory- The company's decision to reduce debt aligns with this theory. It
acknowledges the trade-off between the tax benefits of debt and the costs of
financial distress. By lowering debt, Offices Ltd. aims to reduce interest expense and
the risk of financial distress.
Pecking Order Theory-The company's preference for a rights issue, which is a less
costly form of equity financing, supports this theory. This theory states that
companies prefer internal financing first, followed by debt, and lastly by equity.
2024
SEMESTER 2
2024
, QUESTION 1
a.) Capital Structure and Risk/Return
Changing a company's capital structure directly impacts its risk profile and expected
return.
Increased Debt (Higher Leverage)- Higher debt levels increase financial risk. This
means
Higher Interest Expense-This reduces profits, making the company more
vulnerable to economic downturns.
Increased Default Risk- A higher debt burden makes it harder to meet
obligations, potentially leading to bankruptcy.
Higher Expected Return- Investors demand a higher return to compensate for
the increased risk.
Decreased Debt (Lower Leverage)- Lower debt levels decrease financial risk,
leading to
Lower Interest Expense- This improves profitability and makes the company
more stable.
Reduced Default Risk- A lower debt burden makes it easier to meet
obligations, reducing the risk of bankruptcy.
Lower Expected Return- Investors require a lower return due to the reduced
risk.
b.) Capital Structure Theories
The case of Offices Ltd. reflects a combination of capital structure theories
Trade-off Theory- The company's decision to reduce debt aligns with this theory. It
acknowledges the trade-off between the tax benefits of debt and the costs of
financial distress. By lowering debt, Offices Ltd. aims to reduce interest expense and
the risk of financial distress.
Pecking Order Theory-The company's preference for a rights issue, which is a less
costly form of equity financing, supports this theory. This theory states that
companies prefer internal financing first, followed by debt, and lastly by equity.
