Question

Currently the firm has total market value of debt $20 million and total market value of equity $60 million. This capital structure is considered optimal by the management. The optimal capital budget for new investment for the coming period is determined to be $15 million. The total net income is estimated to be $20 million. The firm has 5 million common shares outstanding. The most recent dividend per share is $1 and the management intends to maintain it for the foreseeable future. The management also wants to maintain the optimal capital structure. Which of the following statements is true? Select one: a. After paying dividends the firm still has enough money remaining to meet the equity requirement for the new investments. b. The optimal debt ratio is 30%. c. The firm would need to raise external equity by $1.2 million. d. The dividend payout ratio is 20%.

Answer 1

Optimal Weight of debt = Market value of debt / Market value of debt and equity = $20 million / ($20 million + $60 million) = 0.25

Optimal Weight of equity = 1 - optimal weight of debt = 1 - 0.25 = 0.75

new investment required = $15 million

We apply the optimal weights to this and see how much debt and equity is required -

Debt required = $15 million x 0.25 = $3.75 million

Equity required = $15 million x 0.75 = $11.25 million

Also, Retained earnings available = Net Income - Dividends = $20 million - (5 million x $1) = $15 million

Now, we take a look at the options given -

a) This statement is true. We still have $3.75 million remaining after meeting equity requirement for new investments.

b) This statement is false. Optimal debt ratio is 25%.

c) This statement is false.

d) Dividends payout ratio = Dividends / Net income = $5 million / $20 million = 0.25 or 25%

Therefore, this statement is false.