Considering the question of 'optimal capital structure' in the context of different models, which capital structure theory can best explain the high leverage of Iridium LLC and why?
Solved by verified expertIn my judgement, the net operating income (NOI) theory better explains the high leverage of Iridium LLC than the rest of the theories. One reason for this is that high leverage enabled Iridium increase its output which in turn translated to high revenue and profits. The eventual bankruptcy may have been caused by poor management. Instead of using the high profits realized as a result of increased output to service the loans, this company would have channeled significant profits towards further increment of the output and hiring highly skilled employees. Channeling high profits towards servicing the loans when the company's operational costs were already high was a great mistake since this only accelerated the company towards bankruptcy. The management of the organization was more determined to complete the loans that it had taken than preventing the company from going into bankrupt.
Besides, high leverage enabled Iridium acquire additional assets. The main reason why this company became bankrupt despite having many assets is that the management were not putting the acquired assets into good use. Had the management put the acquired assets into good use the Iridium would have generated high profits which would have in turn channeled towards more acquisition of assets or even into the company's savings account. Leaving some of the company's assets to lie idle costed the company alot of money due to the expenditure that the company was using to maintain some of the assets.
One more reason is that high leverage enabled Iridium expand quickly. Quick expansion enabled the value of the company to increase since the company acquired many assets in the process of expanding. Typically, acquiring such assets as land enables the company's net-worth to increase because these kind of assets appreciate with time. Had the company focused on purchasing assets that appreciate with time, such an approach would have prevented the bankruptcy scenario since the company would have been able to settle settle its huge loans during its great hour of need.
The management of Iridium LLC believed that the only way to increase their organization's value was by leveraging (taking as many loans as possible to finance the operations of the company). This approach caused the company to go bankrupt because the management did not put the loans that they took into good use. Had the management put the borrowed money into good use, the company won't have been overwhelmed by the huge loans. The high interests that the company was paying increased its overall operational cost thereby accelerating it towards bankruptcy.
References
Bajaj, Y., Kashiramka, S., & Singh, S. (2020). Application of capital structure theories: a systematic review. Journal of Advances in Management Research.
Zhao, L. (2018). Literature review of capital structure theory and influencing factors. Modern Economy, 9(10), 1644.
