The Boisjoly Company currently has no debt. An in-house research group has just been assigned the job of determining whether the firm should change its capital structure. Because of the importance of the decision, management has also hired the investment banking firm of Stanley Morgan & Company to conduct a parallel analysis of the situation. Mr. Harris, the in-house analyst, who is well versed in modern finance theory, has decided to carry out the analysis using the MM framework. Ms. Broske, the Stanley Morgan consultant, who has a good knowledge of capital market conditions and is confident of her ability to predict the firm's debt and equity costs at various levels of debt, she has decided to estimate the optimal capital structure as that structure which minimizes the firm's weighted average cost of capital. The following data are relevant to both analyses: EBIT = S4 million per year, in perpetuity Tax rate = 40% Dividend payout ratio = 100% Current required rate of return on equity = 12% The cost of capital schedule predicted by Mr. Harris follows: At a debt level of (millions of dollars) $0 $2 $4$6 $8 $10 Interest rate (%) 8 8.3 9 10 11 Cost of equity 12 12.25 12.75 13 13.15 13.4 $12 13 14.65 $14 16 17 Ms. Broske estimated the present value of financial distress costs at $8 million. Additionally, she estimated the following probabilities of financial distress: At a debt level of millions of dollars) $0 $2 54 56 58 $10 512 514 Probability of financial distress 0 0 0.05 0.07 0.10 0.17 0.47 0.90 a. What level of debt would Mr. Harris and Ms. Broske recommend as optimal? b. Comment on the similarities and differences in their recommendations. c. What factors should a financial manager consider to determine the optimal capital structure? (Explain at least 5 factors) The Boisjoly Company currently has no debt. An in-house research group has just been assigned the job of determining whether the firm should change its capital structure. Because of the importance of the decision, management has also hired the investment banking firm of Stanley Morgan & Company to conduct a parallel analysis of the situation. Mr. Harris, the in-house analyst, who is well versed in modern finance theory, has decided to carry out the analysis using the MM framework. Ms. Broske, the Stanley Morgan consultant, who has a good knowledge of capital market conditions and is confident of her ability to predict the firm's debt and equity costs at various levels of debt, she has decided to estimate the optimal capital structure as that structure which minimizes the firm's weighted average cost of capital. The following data are relevant to both analyses: EBIT = S4 million per year, in perpetuity Tax rate = 40% Dividend payout ratio = 100% Current required rate of return on equity = 12% The cost of capital schedule predicted by Mr. Harris follows: At a debt level of (millions of dollars) $0 $2 $4$6 $8 $10 Interest rate (%) 8 8.3 9 10 11 Cost of equity 12 12.25 12.75 13 13.15 13.4 $12 13 14.65 $14 16 17 Ms. Broske estimated the present value of financial distress costs at $8 million. Additionally, she estimated the following probabilities of financial distress: At a debt level of millions of dollars) $0 $2 54 56 58 $10 512 514 Probability of financial distress 0 0 0.05 0.07 0.10 0.17 0.47 0.90 a. What level of debt would Mr. Harris and Ms. Broske recommend as optimal? b. Comment on the similarities and differences in their recommendations. c. What factors should a financial manager consider to determine the optimal capital structure? (Explain at least 5 factors)
