Question

# Review this situation: Universal Exports Inc. is trying to identify its optimal capital structure. Universal Exports...

Review this situation: Universal Exports Inc. is trying to identify its optimal capital structure. Universal Exports Inc. has gathered the following financial information to help with the analysis.

Debt Ratio

Equity Ratio

rdrd

rsrs

WACC

30% 70% 7.00% 10.50% 8.61%
40% 60% 7.20% 10.80% 8.21%
50% 50% 7.70% 11.40% 8.01%
60% 40% 8.90% 12.20% 8.08%
70% 30% 10.30% 13.50% 8.38%

Which capital structure shown in the preceding table is Universal Exports Inc.’s optimal capital structure? ____________________

Debt ratio = 60%; equity ratio = 40%

Debt ratio = 70%; equity ratio = 30%

Debt ratio = 40%; equity ratio = 60%

Debt ratio = 30%; equity ratio = 70%

Debt ratio = 50%; equity ratio = 50%

Consider this case:

Globex Corp. is an all-equity firm, and it has a beta of 1. It is considering changing its capital structure to 60% equity and 40% debt. The firm’s cost of debt will be 6%, and it will face a tax rate of 35%.

What will Globex Corp.’s beta be if it decides to make this change in its capital structure?

Now consider the case of another company:

US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 6%, and its tax rate is 35%. It currently has a levered beta of 1.15. The risk-free rate is 3.5%, and the risk premium on the market is 8%. US Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm’s level of debt will cause its before-tax cost of debt to increase to 8%.

First, solve for US Robotics Inc.’s unlevered beta. _______________

Use US Robotics Inc.’s unlevered beta to solve for the firm’s levered beta with the new capital structure. ______________

Use US Robotics Inc.’s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. ______________

What will the firm’s weighted average cost of capital (WACC) be if it makes this change in its capital structure?

8.2%

8.7%

7.7%

10.2%

option e. is correct option Universal Exports Optimal Capital Structure . Debt and Equity at 50% because WACC is minimum..

Glob Chem Beta levered if it decides to change the capital structure
= Beta unlevered*(1+(1-tax rate)*Debt/ Equity) =1*(1+(1-35%)*40%/60%) =1.43

US robotics Unlevered Beta =Beta levered/(1+(1-tax rate)*Debt/Equity) = 1.15/(1+(1-35%)*30/70) = 0.8994 or 0.90
US robotics levered Beta =Beta unlevered*(1+(1-tax rate)*Debt/Equity) = 0.8994*(1+(1-35%)*60/40) = 1.7764 or 1.78
Cost of Equity under new beta = Risk Free Rate + Beta *(Market Return - Risk Free Rate) =3.5%+1.7764*8% =17.71%

Weight of Debt* Cost of Debt*(1- Tax Rate)+ Weight of Equity * Cost of Equity =60%*8%*(1-35%)+40%*17.71%= 10.41% or 10.2% (option d is correct option)

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