Question

consider what you feel would be an optional capital structure.

Would your recommendation differ depending on the type of industry? Why/why not?

What would you expect the impact to be on earnings per share (EPS) at an optimal capital structure? Is this impact important to you? Why/why not?

Answer 1

Capital Structure:

• Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, and other investments.
• The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always used in practice, and firms often have a strategic or philosophical view of what the structure should be.
• WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

• E = market value of the firm’s equity (market cap)
  D = market value of the firm’s debt
  V = total value of capital (equity plus debt)
  E/V = percentage of capital that is equity
  D/V = percentage of capital that is debt
  Re = cost of equity (required rate of return)
  Rd = cost of debt (yield to maturity on existing debt)
  T = tax rate

Capital Structure depending upon industry:  

Capital structures can vary significantly by industry. Cyclical industries like mining are often not suitable for debt, as their cash flow profiles can be unpredictable and there is too much uncertainty about their ability to repay the debt.

Other industries like banking and insurance use huge amounts of leverage and are their business models require large amounts of debt.

Private companies may have a harder time using debt over equity, particularly small business which are required to have personal guarantees from their owners.

impact of earnings per share (EPS) at an optimal capital structure:  

If the firm has capital structure with high debt content, then EPS will be low in the firm.

Thanks.

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