Question

Flashtronics is trying to determine its optimal capital structure. The company’s capital structure consists of debt and common stock.  In order to estimate the cost of debt, the company has produced the following table:

Debt-to-total-              Equity-to-total-               Debt-to-equity           Bond      B-T cost

assets ratio (w_d)           assets ratio (w_c)               ratio (D/E)                rating      of debt

                                                                                                                                             

0.10                            0.90                      0.10/0.90 = 0.11         AA              6.0%

0.20                            0.80                      0.20/0.80 = 0.25           A               6.6

0.30                            0.70                      0.30/0.70 = 0.43           A               7.3

0.40                            0.60                      0.40/0.60 = 0.67          BB              7.9

0.50                            0.50                      0.50/0.50 = 1.00           B               8.7

The company’s tax rate is 35 percent.

The company currently has a D/E ratio of 20% and uses the CAPM to estimate its cost of common equity, k_s.  The risk-free rate is 4.5 percent and the market risk premium is 6 percent. Flashtronics’ current beta is 1.3.

On the basis of this information, what is Flashtronics’ optimal capital structure, and what is the firm’s weighted average cost of capital (WACC) at this optimal capital structure?You must show the WACC to two decimal places at each debt level.

Answer 1

Optimum capital structure is the point where the weighted average cost of capital (WACC) is the minimum. We have got 5 scenarios here and we will calculate WACC for each of them. The WACC which is the lowest among the 5 should be chosen.

Cost of equity (ks) = Rf + Beta (Market risk premium) = 4.5% + 1.3 (6%) = 12.3%

W(equity) = weight of equity; W(debt) = weight of debt); kd = cost of debt; T = tax rate

Scenario 1 :- Debt and equity is 0.10 and 0.90 respectively

WACC = W(equity) * ks + W(debt) * kd * (1-T) = 0.90(12.3%) + 0.10(6%)(1-30%) = 11.49%

Scenario 2 :- Debt and equity is 0.20 and 0.80 respectively

WACC = 0.80(12.3%) + 0.20(6.6%)(1-30%) = 10.76%

Scenario 3 :- Debt and equity is 0.30 and 0.70 respectively

WACC = 0.70(12.3%) + 0.30(7.30%)(1-30%) = 10.14%

Scenario 4 :- Debt and equity is 0.40 and 0.60 respectively

WACC = 0.60(12.3%) + 0.40(7.90%)(1-30%) = 9.59%

Scenario 5 :- Debt and equity is 0.50 and 0.50 respectively

WACC = 0.50(12.3%) + 0.50(8.70%)(1-30%) = 9.20%

Therefore, the optimum capital structure of the company is 50% debt and 50% equity because at this capital mix, the WACC is the lowest.