Kitchen Tools Repurchase Plan

The mid$-$sized manufacturer of kitchen tools is considering a stock repurchase in response to an unsolicited takeover offer. The company is looking to determine the optimal debt capacity and capital structure that will result in a change in firm value and stock price. This case study will analyze the financial position of the company and provide recommendations on the optimal debt capacity and capital structure to be used.

The mid$-$sized manufacturer of kitchen tools has a stable financial position with a strong balance sheet. The company currently has $$10$ million in cash and $$30$ million in equity. The company's current capital structure consists of $100\%$ equity, with no debt. The company is considering taking on debt to fund a stock repurchase and increase shareholder value.

The company has a beta of $1\mathrm{.}2,$ and the risk$-$free rate is $3\%.$ The company's current cost of equity is estimated to be $12\%,$ and the corporate tax rate is $35\%.$ The company's current earnings before interest and taxes $($EBIT$)$ are $$5$ million, and the company has no growth opportunities.

Question:

$1.$ What is the firm$$s optimal debt capacity and capital structure? Explain.