Essay About Negative Signal And Lower Return

Hill Country
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Question 3: We would like to advise Hill Country Food Snacks to undergo a debt-to-structure of xx%. The rationale behind why a firm should add debt to its capital structure is because of the cost reductions, ownership rights, and tax savings associated with it. First, relative to equity, debt requires a lower return. The reason why debt provides a lower return is because the firm is required to make interest payments and return the principle at maturity to debt holders. In addition, if a company goes under, debt holders would have senior claims to the company’s assets. On the other hand, equity holders have the final claim, which demands a higher return. In turn, companies often mix debt into their capital structure to bring down the cost of capital (WACC). Secondly, by adding debt, the company avoids dilution of ownership. If a firm was to issue equity, it would have to share the profits it generates with additional shareholders. However, if a firm uses debt financing, it only needs to only pay interest out of its profits. Equity investors welcome the idea of debt, but up to a certain extent. If a firm becomes too levered, it would be at risk of financial distress and not be able to satisfy its interest obligations. Lastly, using debt helps lower the company’s taxes because of interest deductions. The lower the taxable income, the less taxes a company pays. On the other hand, dividends paid to equity holders are not tax-deductible and must come from after-tax income. Therefore, tax savings help further reduce a company’s debt financing cost, which is an advantage that equity financing lacks. With respect to signaling, an announcement regarding a firms debt can foresee a stocks future performance. Typically, if a firm issues debt, it signals positive news and the share price will rise. Conversely, an announcement that states that debt will be taken on at a future date sends a negative signal about the company and will usually correlate with a decline in share price.  All in all, there is an optimal level of debt a firm should take on, which is where the cost of capital is at its lowest. If that holds, a firm would be able to do the following: take advantage of the tax benefits, undergo wise investments, avoid excessive risks, provide more returns for its investors, and be able to satisfy its interest obligations.  [pic 1]