1. Why should a firm have a capital structure policy, i.e. a target debt ratio?
A capital structure policy aims to balance the trade-off between the benefits of debt financing (interest tax shield) and the costs of debt financing (financial distress and agency costs). Every firm should set its target capital structure such that its cost and benefits of leverage ultimately maximise the firm’s value. Graham and Harvey asked 392 firms’ chief financial officers whether they use target debt ratios. Results show that the majority of them do, although the level of strictness of the target policy varies across different companies. Only 19% of the firms avoid target ratios, of which most are likely to be the relatively smaller firms. This clearly …show more content…

Although its debt ratio rose from 7% in 1972 to 27% in 1975 and interest coverage decreased from 38.4 to 4.6, the firm was able to retain its AAA bond rating during the period (due to its well maintained low debt level which allowed the firm room to take on more debt should the need arise). Under the 25% debt scenario, with an interest coverage ratio of 6.17, Du Pont would continue to receive an AAA bond rating.
As the result of the acquisition of Conoco, Du Pont’s debt ratio rose to nearly 40% in 1982 and interest coverage dropped to record low of 4.8, yielding an AA rating for the firm. The results of these indicators are similar to those that would be observed under the 40% debt scenario. Hence, Du Pont would receive AA rating under the higher debt alternative.
Financial performance: In terms of the financial performance under the two alternative debt policies, we evaluate different measures including return on equity (ROE), earning per share (EPS) and dividends per share (DPS). From table 1, forecasted statistics indicate that performances under the 40% debt scenario outperform those under the 25% debt scenario for all indicators. With ROE of 11.4%, EPS of 6.62 and DPS of 3.64