Question

Integrative—Optimal capital structure   Medallion Cooling​ Systems, Inc., has total assets of $10,500,000​, EBIT of $2,050,000​, and preferred dividends of $201,000 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, rd	Number of common stock shares	Required​ return, rs
0%	0%	201,000	11.8%
15	7.7	168,000	13.2
30	9.1	137,000	13.8
45	12.1	108,000	16.1
60	14.8	85,000	20.2

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

b. Use the equation P0=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

*EPS = Earnings available / Shares O/s

* Price = EPS / Required rate