Question

Understanding the optimal capital structure

Review this situation: 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 |
EPS |
DPS |
Stock Price |
---|---|---|---|---|

30% | 70% | 1.25 | 0.55 | 36.25 |

40% | 60% | 1.40 | 0.60 | 37.75 |

50% | 50% | 1.60 | 0.65 | 39.50 |

60% | 40% | 1.85 | 0.75 | 38.75 |

70% | 30% | 1.75 | 0.70 | 38.25 |

**1)** Which capital structure shown in the
preceding table is Transworld Consortium Corp.’s optimal capital
structure?

Debt ratio = 50%; equity ratio = 50%

Debt ratio = 70%; equity ratio = 30%

Debt ratio = 30%; equity ratio = 70%

Debt ratio = 60%; equity ratio = 40%

Debt ratio = 40%; equity ratio = 60%

Consider this case:

Globex Corp. has a capital structure that consists of 40% debt and 60% equity. The firm’s current beta is 1.25, but management wants to understand Globex Corp.’s market risk without the effect of leverage.

**2)** If Globex Corp. has a 25% tax rate, what is
its unlevered beta?

0.91

0.95

0.83

0.79

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 8%, and its tax rate is 25%. It currently has a levered beta of 1.25. The risk-free rate is 3.5%, and the risk premium on the market is 7%. 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 10%.

**3)** First, solve for US Robotics Inc.’s
unlevered beta. .95/.86/1.14/1.05 ?

Use US Robotics Inc.’s unlevered beta to solve for the firm’s levered beta with the new capital structure. 2.22/1.82/1.92/2.02 ?

Use US Robotics Inc.’s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. 17.640/ 15.876/ 20.286/ 14.112% ?

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

9.86%

8.70%

11.60%

11.02%

Answer #1

1) Optimum capital structure is that which creates maximum
shareholder value. Therefore in above case **option
4th** is correct.

Debt ratio = 60% ; equity ratio = 40%

2)Unlevered beta = Current Beta / 1+[(1- Tax Rate )* Debt Equity Ratio]

=1.25 /1+[(1-0.25)*0.40/0.60]

= .83

Unlevered beta is 3rd option (.83)

3) unlevered beta = 1.25/1+(1-.25)*(.30/.70) = .95

Levered Beta = .95(1+(.75)(.60/.40). = 2.02

Cost of Equity = .035+2.02(.07) = 17.64%

4) Weighted average cost of capital (WACC)

.60(.10)(1-.25)+ .40(.1764) = 11.60%

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%;...

Review the following situation:
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
(%)
EPS
DPS
Stock
Price
30
70
1.55
0.34
22.35
40
60
1.67
0.45
24.56
50
50
1.72
0.51
25.78
60
40
1.78
0.57
27.75
70
30
1.84
0.62
26.42
Which capital structure shown in the preceding table is
Transworld Consortium Corp.’s optimal capital structure?
Debt...

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 (%)
30
70
6.02
9.40
9.71
40
60
6.75
9.750
9.55
50
50
7.15
10.60
10.02
60
40
7.55
11.30
10.78
70
30
8.24
12.80
11.45
Which capital structure shown in the preceding table is
Transworld Consortium Corp.’s optimal capital structure?
A) Debt ratio = 40%;...

4. Determining the optimal capital
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rate is 25%. It currently has a levered beta of 1.10. The risk-free
rate is 2.5%, and the risk premium on the market is 7.5%. 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...

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 25%. It currently has a levered beta of 1.10. The risk-free
rate is 3%, and the risk premium on the market is 7.5%. 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...

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Right now, it has a capital structure that consists of 20% debt and
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(rM – rRF) is 5%. Currently the company’s cost of equity, which is
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