6. 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	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 Universal Exports Inc.s optimal capital structure?

Debt ratio = 40%; equity ratio = 60%

Debt ratio = 70%; equity ratio = 30%

Debt ratio = 50%; equity ratio = 50%

Debt ratio = 60%; equity ratio = 40%

Debt ratio = 30%; equity ratio = 70%

Consider this case:

Globex Corp. currently has a capital structure consisting of 30% debt and 70% equity. However, Globex Corp.s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 3.5%, the market risk premium is 8%, and Globex Corp.s beta is 1.25.

If the firms tax rate is 35%, what will be the beta of an all-equity firm if its operations were exactly the same?

Now consider the case of another company:

U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 35%. It currently has a levered beta of 1.25. The risk-free rate is 3.5%, and the risk premium on the market is 8%.U.S. 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 12%.

First, solve for U.S. Robotics Inc.s unlevered beta.

Relever U.S. Robotics Inc.s beta using the firms new capital structure.

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

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

12.3%

8.0%

13.5%

8.6%