The Capital Structure Decision and the Cost of Capital

FIN 501

Case Analysis: The Capital Structure Decision and The Cost of Capital/Module 4

Determining the optimal capital structure varies from company to company. The common problem with determining this ideal structure comes by way of determining the optimal debt to equity ratio. CFOs of companies are paid generously to make this very important decision. Quite simply put, the cost of debt is much cheaper than the cost of equity for a company. In theory, the optimum debt to equity ratio using this logic would be almost entirely all debt and very little equity. But this theory starts to fall apart as companies start to borrow more and more and the shareholders start to feel nervous because they begin to realize that if the company liquidates, they will lose most if not all of their investment. Feeling this way, they then begin to sell their shares and the company’s value begins to fall. So this is where the CFO comes in and decides where this point is that shareholders will tolerate debt without selling off their shares of stock; in other words, the optimal capital structure for the company. In this paper, I will look at three companies: Ford, Disney, and Electronic Arts (EA), and recommend the capital structure I feel they should use taking into consideration the nature of their business, the riskiness of the company and the advantages and disadvantages of debt over equity financing.

Looking at Ford Motor Company, we see that they design, develop, manufacture and service cars and trucks worldwide with significant international operations throughout Europe, Asia and South America. Domestically, Ford along with numerous other auto companies faced historical challenges in late 2008 through 2009. Needless to say, Ford along with the other major car companies needed to relook at their capital structure in order to stay afloat. Considering the type of business Ford is in and the actions taken by Ford to avert...