ACC307 | Accounting Theory | The Company’s Debt And Equity

1.a. The capital structure is regarded as the amount of debt and equity that is employed by the firm to fund the operations and finance the assets. The debt and equity is regarded as the important element of capital structure because they are used to fund the operations of business, capital expenses, acquisition and other investments. There are trade-off firms that have to decide whether to increase the debt or equity and managers would balance both in order to find the optimal capital structure. The capital structure is the mix of company’s debt and equity they are important because it costs the company the amount of money to borrow.

b. Attaining the right structure of capital particularly the composition of debt and equity which is used by the company to finance its operations and strategic investment has vexed the practitioners. An appropriate capital structure helps in providing tax benefit because interest expenditure is tax deductible. A right capital structure helps in maintaining the low leverage and supports the greater level of leverage with collateral. The appropriate capital structure helps in mitigating the refinancing of risk by matching the debt and asset maturity.

c. Leverage is measured by the company’s debt and equity. The degree of financial leverage measures the sensitivity of the company’s earnings per share with respect to its fluctuations in the operating income as the outcome of changes in the capital structure. The financial leverage varies between companies because companies relies on mixture of equity and debt to finance their operations and understanding the amount of debt that is held by the company in evaluating whether it can pay its debts. If the company does not have any appropriate level of taxable income to protect or if the company’s operating profit is lower than the critical level, then the financial leverage would reduce the value of equity and hence reduce the company value.

2.a. Future contracts is treated as one of the most common derivatives that is used to hedge risk. The ultimate goal of the investors using the future contract is to hedge and perfectly offset the risk. The future contract is identical to options. The holder of future contract has the right of purchasing the underlying security where both the party are obligated to deliver based on the terms of contract if the settlement takes place. Buying a future contract is useful for investors in restricting the exposure of risk that an investor usually has in trade.

b. Perfect hedges are real in theory, but they are rarely considered worthy for any time period except during the most volatile markets. In this situation, perfect hedge is referred as the safe haven for capital in the volatile markets. When the term perfect hedge is thrown in the finance world which usually implies that the ideal hedge is determined by speaker’s own tolerance risks. The most common example of perfect hedge would be the investors employing the combination of stocks that are held and opposing the position of options to self-insure against any loss that are held in the stock.

c.i. The wool grower should undertake the short position in the future market because the future expectation is that the price would drop and the price at which she would be selling is higher than the price she would buy later.

ii. Short selling puts the investors in the position of limitless risks and limited reward. The investor here should take into the account the risk as managing risk during the short run is similar to purchasing stock.

d. Due to the different types of coal in the market, different benchmarks has grown relating to the price of numerous forms of coal. These price becomes a basis of future contracts that are traded on the exchange across the world. There are demand side factors is treated as the strongest factor that changes the price of coal. While the supply the supply side factors does not bears much of the weight on the future coal price. However, much of the supply in the end is bound to overweigh the coal demand that ultimately brings down price of the coal.