Question

8. Determining the optimal capital structure Understanding the optimal capital structure Review this situation: Universal Exports Inc. is trying to identify its optimal capital structure. Universal Exports Inc. has gathered the following financial information to help with the analysis. Debt Ratio Equity Ratio EPS DPS Stock Price 30% 70% 1.55 0.34 22.35 40% 60% 1.67 0.45 24.56 50% 50% 1.72 0.51 25.78 60% 40% 1.78 0.57 27.75 70% 30% 1.84 0.62 26.42 Which capital structure shown in the preceding table is Universal Exports Inc.’s optimal capital structure? Debt ratio = 50%; equity ratio = 50% Debt ratio = 30%; equity ratio = 70% Debt ratio = 70%; equity ratio = 30% Debt ratio = 60%; equity ratio = 40% Debt ratio = 40%; equity ratio = 60% Consider this case: Globex Corp. currently has a capital structure consisting of 40% debt and 60% equity. However, Globex Corp.’s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 3%, the market risk premium is 7.5%, and Globex Corp.’s beta is 1.15. If the firm’s tax rate is 35%, what will be the beta of an all-equity firm if its operations were exactly the same? Now consider the case of another company: U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 35%. It currently has a levered beta of 1.15. The risk-free rate is 3%, and the risk premium on the market is 7.5%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm’s level of debt will cause its before-tax cost of debt to increase to 12%. Use the Hamada equation to unlever and relever the beta for the new level of debt. What will the firm’s weighted average cost of capital (WACC) be if it makes this change in its capital structure? (Hint: Do not round intermediate calculations.) The optimal capital structure is the one that the WACC and the firm’s stock price. Higher debt levels the firm’s risk. Consequently, higher levels of debt cause the firm’s cost of equity to .

Answer 1

Which capital structure shown in the preceding table is Universal Exports Inc.’s optimal capital structure?
Debt ratio = 60%; equity ratio = 40%
Optimal capital structure is one which maximizes the stock price

Consider this case: Globex Corp. currently has a capital structure consisting of 40% debt and 60% equity. However, Globex Corp.’s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 3%, the market risk premium is 7.5%, and Globex Corp.’s beta is 1.15. If the firm’s tax rate is 35%, what will be the beta of an all-equity firm if its operations were exactly the same?
=beta/(1+(1-tax rate)*Debt/Equity)
=1.15/(1+(1-35%)*40%/60%)
=0.802325581

What will the firm’s weighted average cost of capital (WACC) be if it makes this change in its capital structure?
=60%*12%*(1-35%)+40%*(3%+7.5%*(1.15/(1+(1-35%)*30%/70%)*(1+(1-35%)*60%/40%)))
=11.2092%

The optimal capital structure is the one that minimizes the WACC and maximizes the firm’s stock price. Higher debt levels increase the firm’s risk. Consequently, higher levels of debt cause the firm’s cost of equity to increase.