Fall term 2018 Doç Dr S.J. Terregrossa, Ph.

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Study guide/problem set 6
ECO 191 Microeconomics Istanbul Aydin University

Question 1:

Firm Z requires a 2,000,000 capitalization. To achieve this capitalization, Firm Z plans to

borrow 500,000 and issue and sell 75,000 shares of common stock for 20 each.
What is the capital structure (financing mix) of Firm Z for this capitalization?
(In other words, calculate the capital structure of Firm Z, regarding this particular
capitalization.)

Question 2:

Notes: Firms do prefer to include some debt in their capital structure (financing mix), for a
given capitalization. (More specifically, it is the owners of the firm (ie. the shareholders) who
want to include some debt in the firm’s capital structure (financing mix), for a given
capitalization.)
The reason for this is that there are potential benefits to the owners of the firm, when some
debt is included in the capital structure. The main benefit is increased share value.
The analytical narrative:
a) End-of-fiscal period share value is largely determined by end-of-fiscal period net
profit per share (EPS). The greater is EPS, the greater is share value.
Net profit per share (EPS) is equal to end-of-fiscal period net profit divided by the number of
shares outstanding.
b) The inclusion of some debt in the firm’s financing mix (for a given capitalization)
leads to greater end-of-fiscal period net profit per share (EPS), and thus greater share
value, for two reasons:
i) Annual interest paid on the firm’s debt is tax deductable, which means that the
firm pays less taxes when there is some debt included in the capital structure. Less
taxes paid means greater net profit, and thus greater net profit per share, for a
given amount of shares outstanding.
ii) When there is some debt included in the firm’s financing mix (for a given
capitalization) there is less reliance on equity finance in the form of issuing and
selling new shares of common stock. Fewer shares issued means fewer shares-
outstanding, which leads to greater net profit per share, for a given amount of net
profit (ie. dividing up net profit among fewer ownership shares).

c) Thus, the more debt included in the firm’s capital structure, the greater are the
monetary benefits (see i and ii above), and the greater is the potential end-of-fiscal
period share value (which is is largely determined by end-of-fiscal period net profit
per share (EPS). The greater is EPS, the greater is share value.)

d) However, the more debt in the firm’s financing mix (for a given capitalization), the
greater is the exposure to bankruptcy risk. Too much exposure to bankruptcy risk
can put downward pressure on share value. In fact if there is too much debt in the
capital structure (for a given capitalization), then gains in share value from having
debt in the financing mix can be completely offset, resulting in an overall decrease in
end-of-fiscal period share value.
 e) Thus achieving the optimal capital structure for a firm (for a given capitalization) is
a balancing act for the firm’s management: Including debt in the financing mix to reap
the monetary benefits (as explained above), but without too much exposure to
bankruptcy risk, which puts downward pressure on share value.

(Optimal capital structure means the financing mix that leads to maximum share value).

Based on the above analytical narrative (which was also explained in class), answer
the following question:

Question: Explain how a firm determines how much debt the firm can safely have in its
capital structure (for a given capitalization), to achieve an optimal capital structure.
(This was also explained in class.)

Question 3:
At the beginning of the fiscal year (October 31, 2018), Firm Z goes public and issues 500,000
shares of common stock. CEO Orhan (previously the sole owner of the firm) obtains
ownership of 300,000 shares, and offers the remaining 200,000 shares to outside investors for
10 each (which is beginning-of-period share value). Household J purchases the entire public
offering (IPO) on October 31, and thus provides a 2,000,000 capitalization. Explain
CEO Orhan maintains operational control of the firm. a) Explain why.
CEO Orhan uses the 2,000,000 capitalization to acquire new K, to increase the productive
capacity of the firm.
At the end of the fiscal year (October 30, 2019) Firm Z has generated 10,000,000 in net
profit. b) Explain what net profit is. c) How much of this money belongs to CEO Orhan?
How much of this money belongs to Household J? Explain.
At the end of the fiscal year CEO Orhan decides to pay out 8,000,000 of the net profit as
dividends. d) What is the total amount of equity financing that Firm Z has obtained
during the fiscal year? Explain your answer.

Question 4:
At the beginning of the fiscal year (October 31, 2018), Firm Z goes public and issues 500,000
shares of common stock. CEO Orhan (previously the sole owner of the firm) obtains
ownership of 300,000 shares, and offers the remaining 200,000 shares to outside investors for
10 each (which is beginning-of-period share value). Household J purchases the entire public
offering (IPO) on October 31, and thus provides a 2,000,000 capitalization.
On January 5, 2019 Household J sells its shares for 20 each to Household X. a) Explain
what type of transaction this is.
CEO Orhan maintains operational control of the firm. b) Explain why.
CEO Orhan uses the 2,000,000 capitalization provided by Houshold J to acquire new K, to
increase the productive capacity of the firm.
At the end of the fiscal year (October 30, 2019) Firm Z has generated 10,000,000 in net
profit. b) Explain what net profit is. c) How much of this money belongs to CEO Orhan?
How much of this money belongs to Household J? How much of this money belongs to
Household X? Explain each answer.
At the end of the fiscal year CEO Orhan decides to pay out 8,000,000 of the net profit as
dividends. d) What is the total amount of equity financing that Firm Z has obtained
during the fiscal year? Explain your answer.
Question 3:
At the beginning of the fiscal year (October 31, 2018), Firm Z goes public and issues 500,000
shares of common stock. CEO Orhan (previously the sole owner of the firm) obtains
ownership of 300,000 shares, and offers the remaining 200,000 shares to outside investors for
10 each (which is beginning-of-period share value). Household J purchases the entire public
offering (IPO) on October 31, and thus provides a 2,000,000 capitalization.
On January 5, 2019 CEO Orhan issues 300,000 additional shares of common stock and offers
CEO Orhan maintains operational control of the firm. a) Explain why.
CEO Orhan uses the 2,000,000 capitalization to acquire new K, to increase the productive
capacity of the firm.
At the end of the fiscal year (October 30, 2019) Firm Z has generated 10,000,000 in net
profit. b) Explain what net profit is. c) How much of this money belongs to CEO Orhan?
How much of this money belongs to Household J? Explain.
At the end of the fiscal year CEO Orhan decides to pay out 8,000,000 of the net profit as
dividends. d) What is the total amount of equity financing that Firm Z has obtained
during the fiscal year? Explain your answer.