Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

North Star is trying to determine its optimal capital structure, which now consists of only common equity. The firm will add debt to its capital

image text in transcribed
image text in transcribed
North Star is trying to determine its optimal capital structure, which now consists of only common equity. The firm will add debt to its capital structure if it minimizes its WACC, but the firm has no plans to use preferred stock in its capital structure. In addition, the firm's size will remain the same, so funds obtained from debt issued will be used to repurchase stock. The percentage of shares repurchased will be equal to the percentage of debt added to the firm's capital structure. (In other words, if the firm's debt-to-capital ratio increases from 0 to 25%, then 25% of the shares outstanding will be repurchased.) North Star is a small form with average sales of $25 million or less during the past 3 years, so it is exempt from the interest deduction limitation. Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm's debt cost at different debt levels: Debt-to-Capital Ratio Equity-to- Capital Ratio Debt-to-Equity Ratio Before-Tax Cost of Debt Bond Rating (wa) (WJ (D/E) (ra) 0.00 1.00 0.0000 TAA 5.0% 0.25 0.75 0.3333 IA 6.0 0.50 0.50 10000 BBB 8.3 0.75 0.25 3.0000 BB 11.0 The firm has total capital of $5 million and 200,000 shares of common stock outstanding. Its EBIT is $500,000 and will not change if debt, at any of the levels shown in the preceding table, is added to the firm's capital structure. North Star uses the CAPM to estimate its cost of common equity, . It estimates that the risk-free rate is 3.5%, the market risk premium is 4.5%, and its tax rate is 25%. North Star's current beta, which is because it has no debt, is 1.25. Calculate the firm's net income for each of the capital structures shown in the preceding table. (wa) (W) (ra) EBIT NI 0.00 1.00 5.0% 500,000 0.25 0.75 6.0 500.000 0.50 0.50 8.3 500.000 0.75 0.25 11.0 500,000

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image_2

Step: 3

blur-text-image_3

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Bakers Health Care Finance Basic Tools For Nonfinancial Managers

Authors: Thomas K. Ross

6th Edition

1284233162, 978-1284233162

More Books

Students also viewed these Finance questions