3. You are an investment banker who has two meetings today. Each of these meetings entails clients requesting your services in determining the optimal capital structure for their firms. For each of the cases below, describe whether you would recommend that the firm choose leverage which is less than, about the same as, or greater than the average across all firms. Explain your reasoning fully.
a) Your morning meeting is with the CEO of a steel company trading at $32 per share. It has Net Income of $40 million and 5 million shares outstanding. While she tells you that this stock price is somewhat understandable, she convinces you that the market is punishing her too much. Afterall, the firm continues to generate a steady flow of earnings in its tangible steel business. Note: the Corporate Tax Rate is 20%; interest paid by the firm is $5 million. [12 points]
b) Your afternoon meeting is with the CEO of a drug company. The firm struggled mightily in its early years and still has significant tax loss carry forwards; but after those difficult and volatile years, now is generating high profits with upcoming attractive – albeit capx-intensive – projects in the pipeline. The firm is thinking about funding the $100 million for current needs by adding debt on to its current debt level of $500 million. The firm’s stock price is $40/share and they have 25 million shares outstanding. [12 points]