CAPITAL STRUCTURE AND DIVIDEND PAYOUTS The board of directors of Angelina Corporation met today to discuss the capital s

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CAPITAL STRUCTURE AND DIVIDEND PAYOUTS
The board of directors of Angelina Corporation met today to
discuss the capital structure and dividend policy of
the company. The board discussed the capital structure of 60
percent debt and 40 percent equity. During the meeting it came up
that debt provides tax benefits to the firm because interest is tax
deductible whereas dividend is not. But the debt ratio of 60
percent was not supported by some board members. One board member,
Robert Smith wanted the capital structure to be 40% debt and 60%
equity because he believes that a high debt ratio increases the
financial risk of the business. Jeff Warren, the CFO of the
company, stressed in his presentation to the board that debt can
put pressure on the firm because interests and principal payments
are fixed obligations that the company must pay, no matter the
profit of the company. He stated that if these obligations are not
met, the company may risk some sort of financial distress and files
for bankruptcy. Jeff continued to explain that if the company files
for bankruptcy there are direct and indirect costs as well as
agency costs that the company must incur.
Alexis Bailey, another board member suggested that there are
ways to reduce the cost of debt by hiring an expert to handle the
company’s debt agreements between the shareholders and bondholders.
She stated that protective covenants are incorporated as part
of the loan agreement and must be taken seriously because a broken
covenant can lead to default. She believed that costs of debt can
be reduced with negative covenants (also called restrictive
covenants) and positive covenants. John Miller, the Investor
Relations Officer stated that one reason bankruptcy costs are so
high is that different creditors and their lawyers contend with
each other. He suggested that if debt can be consolidated, or
if bondholders can be allowed to purchase stock of the company
bankruptcy cost will be reduced. In this way, stockholders and
debtholders are not pitted against each other because they are not
separate entities. He cited examples in Japan where large banks
generally take significant stock positions in the firms to which
they lend money.
The employee representative on the board, Ms. Johnson used the
agency costs to explain that when a firm has debt, conflicts of
interest arise between stockholders and bondholders. Because of
this, stockholders are tempted to pursue selfish strategies. These
strategies are costly because they will lower the market value of
the firm. Philip Suzuki, director of Marketing and a board member
was of the view that determining optimal debt-equity ratio is not
an easy task and varies across industries so the company should
follow the rules of the pecking-order theory when
financing capital projects. No agreement was reached on the
company’s capital structure, but the CEO and Jeff believed that the
32-68 debt-equity ratio discussed in the previous week will
minimize the cost of capital and improve the value of the firm.
The board is retaining you as the financial consultant to assist
with the company’s capital structure and dividend payout decisions.
The Chairman of the board wants you to address the following
questions:
i. Explain a call option and a put option to Amber.
ii. Explain the circumstances under which Amber will want to buy
each of the options.