Question

An analyst is trying to determine the optimal capital structure for a manufacturing firm. Based on current credit markets and the risk of the company, he has the following estimates for different capital weights:

	Structure A	Structure B	Structure C	Structure D
MV of Debt	$0	$5,000	$10,000	$15,000
MV of Equity	$20,000	$15,000	$10,000	$5,000
YTM of debt	0.00%	6.00%	8.38%	10.10%
Beta	1.20	1.29	1.39	1.94

The current risk free rate is 3.00%, while the market portfolio risk premium is 6.00%. The tax rate facing the firm is 39.00%.

Which structure is optimal for the firm? (A, B, C, or D)

Answer 1

Structure A:

kE = rF + beta[MRP]

= 3% + [1.20 x 6%] = 3% + 7.2% = 10.2%

As it is equity only structure, so, its WACC = kE = 10.2%

Structure B:

kE = rF + beta[MRP]

= 3% + [1.29 x 6%] = 3% + 7.74% = 10.74%

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [(5/20) x 6% x (1 - 0.39)] + [(15/20) x 10.74%] = 0.915% + 8.055% = 8.97%

Structure C:

kE = rF + beta[MRP]

= 3% + [1.39 x 6%] = 3% + 8.34% = 11.34%

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [(10/20) x 8.38% x (1 - 0.39)] + [(10/20) x 11.34%] = 2.56% + 5.67% = 8.23%

Structure D:

kE = rF + beta[MRP]

= 3% + [1.94 x 6%] = 3% + 11.64% = 14.64%

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [(15/20) x 10.10% x (1 - 0.39)] + [(5/20) x 14.64%] = 4.62% + 3.66% = 8.28%

As the WACC is lowest for Structure C, so, it is the optimal structure for the firm.