To determine whether your firm should move to its optimal mix (and if so, how) and to analyze the right type of debt for your firm.

Key Questions

• If your firm’s actual debt ratio is different from its “recommended” debt ratio, how should they get from the actual to the optimal? In particular,

a. should they do it gradually over time or should they do it right now?

b. should they alter their existing mix (by buying back stock or retiring debt), should they invest in new projects with debt or equity or should they change how much they return to stockholders?

• What type of financing should this firm use? In particular,

a. should the financing be short-term or long-term?

b. what currency should it be in?

c. what special features should the financing have?

Framework for Analysis 1. The Immediacy Question

• If the firm is underlevered, does it have the characteristics of a firm that is a likely takeover target? (Target firms in hostile takeovers tend to be smaller, have poorer project and stock price performance than their peer groups, and have lower insider holdings.)

• If the firm is overlevered, is it in danger of bankruptcy? (Look at the bond rating if the company is rated. A junk bond rating suggests high bankruptcy risk.)

2. Alter Financing Mix or Take Projects • What kind of projects does this firm expect to have? Can it expect to make excess returns on these projects? (Past project returns is a reasonable place to start—see the section under investment returns.)
• What type of stockholders does this firm have? If cash had to be returned to them, would they prefer dividends or stock buybacks? (Again, look at the past. If the company has paid high dividends historically, it will end up with investors who like dividends.)
3. Financing Type • How sensitive has this firm’s value been to changes in macroeconomic variables such as interest rates, currency movements, inflation, and the economy?
• How sensitive has this firm’s operating income been to changes in the same variables?
• How sensitive is the sector’s value and operating income to the same variables?
• What do the answers to the last three questions tell you about the kind of financing that this firm should use?
Getting Information on Mechanics of Capital Structure To get the inputs needed to estimate the capital structure mechanics, you can get the information on macroeconomic variables such as interest rates, inflation, gross national product growth and exchange rates from my Web site. You can get historical information on your own firm by looking at the Value Line page for your firm, which has information for the last fifteen years on revenues and operating income.
Online sources of information: www.stern.nyu.edu/~adamodar/cfin2E/project/data.htm.