Question

A firm that is financed solely through equity considers changing its capital structure to introduce financial leverage. To achieve this objective, the firm would take debt and use the debt proceeds to purchase some of the outstanding common shares. The current market price per share is $10 earnings-before-interest-and-tax, EBIT, of $10 million per year are expected to remain constant into infinity. Firm's tax rate is 50%. The firm is considering the following three alternative amounts of debt which are given along with the required expected rate of return on equity, ke, and the rate of interest on debt, i:

Amount of debt ($ million)                                        0          20        30

Required expected ROR on equity, ke                    10%     12%     15.2%

Required expected ROR on debt, i                           -           5%       8%

What amount of debt is optimal for the firm?

Answer 1

In order to select the best option for capital structure i.e. the amount of debt and equity, the value of the firm should be calculated and the option which gives maximum value of firm should be selected as it will add maximum value for the shareholders.