Question

Integrative Optimal capital structure Medallion Cooling​ Systems, Inc., has total assets of $11,000,000​, EBIT of $1,980,000​, and preferred dividends of $202,000 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

0%

15

30

45

60

Cost of Debt

0%

8.1

9.2

11.8

14.7

Number of common Stock shares

203,000

170,000

138,000

110,000

78,000

Required Return

12.1%

13.3

13.8

15.8

19.8

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

b. Use the equation P₀=EPS/r_s 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

Answer
A)
Assets	$11,000,000
Debt Ratio	Debt	Cost of Debt (rd)	Interest		EBIT	Interest	EBT	Tax(@ 40%)	Net Profit	Preferred Dividend	Profit Available to Common Stock	Shares Outstanding	EPS
0%	0	0%	0	1,980,000	0	1,980,000	792,000	1,188,000	202,000	986000	2,03,000	4.86
15%	$1,650,000	8.10%	$133,650	1,980,000	$133,650	1,846,350	738,540	1,107,810	202,000	905810	1,70,000	5.33
30%	$3,300,000	9.20%	$303,600	1,980,000	$303,600	1,676,400	670,560	1,005,840	202,000	803840	1,38,000	5.82
45%	$4,950,000	11.80%	$584.100	1,980,000	$584.100	1,395,900	558,360	837,540	202,000	635540	1,10,000	5.78
60%	$6,6,00,000	14.70%	$970,200	1,980,000	$970,200	1,009,800	403,920	605,880	202,000	403880	78,000	5.18
Debt = Debt Ratio x Asset Value
EPS = Profit Available to Common Stock/ Shares outstanding
B)
Debt Ratio	EPS	rs	Price
0%	4.86	12.1%	40.14
15%	5.33	13.3%	40.06
30%	5.82	13.8%	42.21
45%	5.78	15.8%	36.57
60%	5.18	19.8%	26.15
Price (Po) = EPS / rs
C)
The optimal capital structure is 30% debt and 70% equity because this will maximize the price of the common stock.