Question

Given the following choices, what is the optimal capital structure for Chip Co.? (Assume that the company's growth rate is 2%.)

		Dividends	Cost of
	Debt Ratio	Per Share	Equity (r s)
	0%	$5.50	11.5%
	25	6.00	12.0
	40	6.50	13.0
	50	7.00	14.0
	75	7.50	15.0

		0% debt; 100% equity
		25% debt; 75% equity
		40% debt; 60% equity
		50% debt; 50% equity
		75% debt; 25% equity

Answer 1

Optimal capital structure is where the share price is maximum.
Cost of Equity Dividend/( Cost of Equity - Growth)
1. For 0% debt Ratio Price of share = 5.5/(11.5% - 2%) = 57.89
2. For 25% debt Ratio Price of share = 6/(12% - 2%) =60.00
3. For 40% debt Ratio Price of share = 6.5/(13% - 2%) = 59.09
4. For 50% debt Ratio Price of share = 7.0/(14% - 2%) = 58.33
5. For 75% debt Ratio Price of share = 7.5/(15% - 2%) = 57.69

25% debt; 75% equity gives optimal capital structure as price = 60.00

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