9. 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%	1.25	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

Which capital structure shown in the preceding table is Universal Exports Inc.s optimal capital structure?

A. Debt ratio = 40%; equity ratio = 60%

B. Debt ratio = 70%; equity ratio = 30%

C. Debt ratio = 50%; equity ratio = 50%

D. Debt ratio = 60%; equity ratio = 40%

E. 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 8%, and it will face a tax rate of 45%.

What will Globex Corp.s beta be if it decides to make this change in its capital structure?

Potential Answers:

A. 1.37

B. 1.78

C. 1.51

D. 1.44

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 8%, and its tax rate is 45%. It currently has a levered beta of 1.15. The risk-free rate is 2.5%, and the risk premium on the market is 7%.

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 10%. Use the Hamada equation to unlever and relever the beta for the new level of debt. What will the firms weighted average cost of capital (WACC) be if it makes this change in its capital structure? (Hint: Do not round intermediate calculations.)

Potential Answers:

A. 8.6%

B. 6.8%

C. 6.4%

D. 9.1%

The optimal capital structure is the one that _________ (potential answer = minimizes or maximizes) the WACC and _________ (potential answer = minimizes or maximizes) the firms stock price. Higher debt levels ___________ (potential answer = decrease or increase) the firms risk. Consequently, higher levels of debt cause the firms cost of equity to ___________ (potential answer = decrease or increase).