4. Determining the optimal capital structure

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	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 Transworld Consortium Corp.s optimal capital structure?

Debt ratio = 30%; equity ratio = 70%

Debt ratio = 70%; equity ratio = 30%

Debt ratio = 50%; equity ratio = 50%

Debt ratio = 40%; equity ratio = 60%

Debt ratio = 60%; equity ratio = 40%

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 65% equity and 35% 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?

1.72

1.32

1.58

1.78

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 3.5%, 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 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.

1.06

.97

.79

.88

Use US Robotics Inc.s unlevered beta to solve for the firms levered beta with the new capital structure.

1.50

1.84

1.67

1.59

Use US Robotics Inc.s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure.

15.2%

12.2%

13.7%

17.5%

What will the firms weighted average cost of capital (WACC) be if it makes this change in its capital structure?

9.0%

8.5%

7.7%

9.9%