Question
4. Determining the optimal capital structure Understanding the optimal capital structure Review this situation: Universal Exports Inc. is trying to identify its optimal capital structure.
4. Determining the optimal capital structure
Understanding the optimal capital structure
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 = 70%; equity ratio = 30%
____ Debt ratio = 60%; equity ratio = 40%
____ Debt ratio = 50%; equity ratio = 50%
____ Debt ratio = 40%; equity ratio = 60%
____ Debt ratio = 30%; equity ratio = 70%
Consider this case:
Globex Corp. is an all-equity firm, and it has a beta of 1. It is considering changing its capital structure to 60% equity and 40% debt. The firms cost of debt will be 6%, and it will face a tax rate of 40%.
What will Globex Corp.s beta be if it decides to make this change in its capital structure?
____ 1.82
____ 1.40
____ 1.47
____ 1.54
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 6%, and its tax rate is 40%. It currently has a levered beta of 1.10. The risk-free rate is 3%, 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 firms level of debt will cause its before-tax cost of debt to increase to 8%.
First, solve for US Robotics Inc.s unlevered beta.
____ 0.79
____ 0.88
____ 0.97
____ 1.06
Use US Robotics Inc.s unlevered beta to solve for the firms levered beta with the new capital structure.
____ 1.67
____ 1.59
____ 1.84
____ 1.50
Use US Robotics Inc.s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure.
_____ 14.7%
_____ 16.9%
_____ 11.8%
_____ 13.2%
What will the firms weighted average cost of capital (WACC) be if it makes this change in its capital structure?
____ 6.6%
____ 6.2%
____ 8.8%
____ 8.4%
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