IntegrativeOptimal

capital structureMedallion Cooling Systems, Inc., has total assets of

$9,400,000,

EBIT of

$2,040,000,

and preferred dividends of

$196,000

and is taxed at a rate of

40%.

In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:

Capital structure debt ratio	Cost of debt, rd	Number of common stock shares	Required return, rs
0%	0%	196,000	11.8%
15	7.7	168,000	13.3
30	8.8	141,000	13.9
45	11.9	114,000	15.9
60	14.9	76,000	19.7

a. Calculate earnings per share for each level of indebtedness.

b. Use the equation

P0=EPS/rs

and the earnings per share calculated in part

(a)

to calculate a price per share for each level of indebtedness.

c. Choose the optimal capital structure. Justify your choice.

a. Calculate earnings per share for each level of indebtedness.

Calculate the EPS below: (Round to the nearest dollar. Round the EPS to the nearest cent.)

Debt Ratio		0%
EBIT	$	2,040,000
Less: Interest	$
EBT	$
Taxes @40%	$
Net profit	$
Less: Preferred dividends	$
Profits available to
common stockholders	$
# shares outstanding	$	196,000
EPS	$

Calculate the EPS below: (Round to the nearest dollar. Round the EPS to the nearest cent.)

Debt Ratio		15%
EBIT	$	2,040,000
Less: Interest	$
EBT	$
Taxes @40%	$
Net profit	$
Less: Preferred dividends	$
Profits available to
common stockholders	$
# shares outstanding	$	168,000
EPS	$

Calculate the EPS below:(Round to the nearest dollar. Round the EPS to the nearest cent.)

Debt Ratio		30%
EBIT	$	2,040,000
Less: Interest	$
EBT	$
Taxes @40%	$
Net profit	$
Less: Preferred dividends	$
Profits available to
common stockholders	$
# shares outstanding	$	141,000
EPS	$

Calculate the EPS below:(Round to the nearest dollar. Round the EPS to the nearest cent.)

Debt Ratio		45%
EBIT	$	2,040,000
Less: Interest	$
EBT	$
Taxes @40%	$
Net profit	$
Less: Preferred dividends	$
Profits available to
common stockholders	$
# shares outstanding	$	114,000
EPS	$

Calculate the EPS below: (Round to the nearest dollar. Round the EPS to the nearest cent.)

Debt Ratio		60%
EBIT	$	2,040,000
Less: Interest	$
EBT	$
Taxes @40%	$
Net profit	$
Less: Preferred dividends	$
Profits available to
common stockholders	$
# shares outstanding	$	76,000
EPS	$

b. The price per share for the

0%

level of indebtedness is

$nothing.

(Round to the nearest cent.)The price per share for the

15%

level of indebtedness is

$nothing.

(Round to the nearest cent.)The price per share for the

30%

level of indebtedness is

$nothing.

(Round to the nearest cent.)The price per share for the

45%

level of indebtedness is

$nothing.

(Round to the nearest cent.)The price per share for the

60%

level of indebtedness is

$nothing.

(Round to the nearest cent.)

c. Choose the optimal capital structure. Justify your choice. (Select the best answer below.)

A.The optimal capital structure would be

45%

debt and

55%

equity because this is the debt/equity mix that maximizes the price of the common stock.

B.The optimal capital structure would be

15%

debt and

85%

equity because this is the debt/equity mix that maximizes the price of the common stock.

C.The optimal capital structure would be

60%

debt and

40%

equity because this is the debt/equity mix that maximizes the price of the common stock.

D.The optimal capital structure would be

30%

debt and

70%

equity because this is the debt/equity mix that maximizes the price of the common stock.