Question

The case states that Space-Age’s optimal capital structure calls for 20 percent long-term debt and 80 percent common equity. However, according to the 1992 balance sheet, the firm’s capitalization ratio is Long-term debt/Total permanent capital = $12,570,000/($12,570,000 + $17,490,000 + 11,310,000) = 0.304 = 30.4 percent, and its total-debt-to-total-assets ratio is $15,540,000/$44,340,000 = 35.1 percent. Do these figures indicate that the capital structure is seriously out of balance, that the company is using far too much debt, and that you should modify the mix of debt and equity used in the forecasts? (Hint: Think about whether the optimal capital structure should be stated in book value or market value terms.)

Answer 1

Optimal capital structure is combination of debt and equity at which stock price of company is highest. This because stock price depends on the WACC of the company. If WACC of company is highest then Stock price is lowest and if WACC is lowest then stock price is highest.Since, WACC is always calculated based on market value weights and cost fo individual capital.

Space-Age’s optimal capital structure calls for 20 percent long-term debt and 80 percent common equity. So this weight must be based on market value. Bool value weight of long term debt is 30.40% and book value weight of total debt (long term + short term debt) is 35.10%. if bool value weight and market value weight of firm is equal then capital structure is seriously out of balance, that the company is using far too much debt. So from given book value calculate market value first and accordingly check the capital structure of company.