1.Transworld Consortium Corp. is trying to identify its optimal capital structure. Transworld Consortium Corp. has gathered the following financial information to help with the analysis.
|Debt Ratio (%)||Equity Ratio (%)||rd%rd%||rs%rs%||WACC (%)|
Which capital structure shown in the preceding table is Transworld Consortium Corp.’s optimal capital structure?
A) Debt ratio = 40%; equity ratio = 60%
B) Debt ratio = 70%; equity ratio = 30%
C) Debt ratio = 50%; equity ratio = 50%
D) Debt ratio = 30%; equity ratio = 70%
E) Debt ratio = 60%; equity ratio = 40%
Consider this case:
2. Globex Corp. currently has a capital structure consisting of 35% debt and 65% equity. However, Globex Corp.’s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 2.5%, the market risk premium is 7%, and Globex Corp.’s beta is 1.25. If the firm’s tax rate is 35%, what will be the beta of an all-equity firm if its operations were exactly the same?
Question 1) This requires us to know the definition of optimal capital structure. Optimal capital structure is mix of debt and equity in company's capital structure such that the weighted average cost of capital is lowest of all options.
Clearly in the table, WACC is lowest when Debt = 50% and equity = 60%. WACC = 9.55%.
Hence, Answer is Option A.
Question 2) Current beta for Globex Corp (GC) = 1.25
This beta is based on debt-to-equity ratio of 35/65
We need to calculate the unlevered Beta for this.
Mathematically, the relation between levered and unlevered equity beta is:
Beta (unlevered) = 1.25/1.35 = 0.259 --> Answer
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