Question

Integrativelong dash—Optimal

capital structure   Medallion Cooling​ Systems, Inc., has total assets of $9,900,000​, EBIT of $1,960,000​, and preferred dividends of $204,000 and is taxed at a rate of 40%.

In an effort to determine the optimal capital​ structure, the firm has assembled data on the cost of​ debt, the number of shares of common stock for various levels of​ indebtedness, and the overall required return on​ investment:

Capital structure debt ratio	Cost of​ debt, r Subscript drd	Number of common stock shares	Required​ return, r Subscript srs
0%	0%	203,000	12.2%
15	7.9	175,000	13.2
30	9.1	145,000	14.2
45	11.9	105,000	16.2
60	14.9	75,000	20.3

a. Calculate earnings per share for each level of indebtedness.

b. Use the equation

Upper P 0 equals EPS divided by r Subscript sP0=EPS/rs and the earnings per share calculated in part ​(a​) to calculate a price per share for each level of indebtedness.

c. Choose the optimal capital structure. Justify your choice.

Answer 1

Total Assets = $9,900,000

EBIT (Earnings before interest and Taxes) = $1,960,000

Preffered Dividends = $204,000

Tax rate = 40%

Earnings per share and price per share for each level of indebtedness is calculated as below

Capital structure debt ratio	Cost of​ debt	Number of common stock shares	Required​ return	Total Debt*	Net Income**	Earning Per Share (Net Income / Number of shares)	Price per Share (EPS / Required return)
0%	0%	203,000	12.20%	0	972,000	4.788	39.24
15%	7.9 %	175,000	13.20%	1,485,000	901,611	5.152	39.03
30%	9.1%	145,000	14.20%	2,970,000	809,838	5.585	39.33
45%	11.90%	105,000	16.20%	4,455,000	653,913	6.227	38.44
60%	14.90%	75,000	20.30%	5,940,000	440,964	5.879	28.96

*Total Debt = Debt Ratio * Total Assets

Debt various levels of Debt ratio

At 0% Debt Ratio, the total debt is = 0 * 9,900,000 = 0

At 15% Debt Ratio, the total debt is = 15% * 9,900,000 = $1,485,000

At 30% Debt Ratio, the total debt is = 30% * 9,900,000 = $2,970,000

At 45% Debt Ratio, the total debt is = 45% * 9,900,000 = $4,455,000

At 60% Debt Ratio, the total debt is = 60% * 9,900,000 = $5,940,000

**Net Income = (EBIT - Debt * Cost of Debt ) * (1 - tax rate) - Preferred Dividends

At 0% Debt Ratio, the Net Income is = [1,960,000 -(0 * 0)]* (1 - 40%) - 204,000 = $972,000

At 15% Debt Ratio, the Net Income is = [1,960,000 -(1,485,000 * 7.90%)]* (1 - 40%) - 204,000 = $901,611

At 30% Debt Ratio, the Net Income is = [1,960,000 -(2,970,000 * 9.10%)]* (1 - 40%) - 204,000 = $809,838

At 45% Debt Ratio, the Net Income is = [1,960,000 -(4,455,000 * 11.90%)]* (1 - 40%) - 204,000 = $653,913

At 60% Debt Ratio, the Net Income is = [1,960,000 - (5,940,000 * 14.90%)]* (1 - 40%) - 204,000 = $440,964

The Optimal Capital Structure of the company is the one where the price per share is maximum because it increases the value of firm as well , So at 30% level of indebtness the price of the share is maximum at $39.33