4. Determining the optimal capital structure Understanding the optimal capital s
ID: 1170165 • Letter: 4
Question
4. Determining the optimal capital structure Understanding the optimal capital structure capital structure. Universal Exports Inc. has gathered the following financial information to help with the analysis. Debt Ratio Equity Ratio rd 30% 40% 50% 60% 70% 70% 60% 50% 40% 30% 7.00% 7.20% 7.70% 8.90% 10.30% rs 10.50% 10.80% 11.40% 12.20% 13.50% WACC 8.61% 8.21% 8.01% 8.08% 8.38% Which capital structure shown in the preceding table is Universal Exports Inc.'s optimal capital structure? Debt ratio-70%; equity ratio-30% Debt ratio-60%; equity ratio 40% Debt ratio-50%; equity ratio-50% Debt ratio-40%; equity ratio-60% Debt ratio-30%; equity ratio-70% Consider this case: Globex Corp. is an all-equity firm, and it has a beta of 1, t is considering changing its capital structure to 65% and 35% debt. The firm's cost of debt will be 10%, and it will face a tax rate of 40%. equity What will Globex Corp.'s beta be if it decides to make this change in its capital structure? Now consider the case of another company:Explanation / Answer
1. Option 3 is correct with Debt Ratio = 50% and Equity = 50% as the WACC is least at 8.01%
Beacuse capital optimum structure is one which has least WACC.
2. Beta Levered BetaL = Betau ( 1+ (1-tax rate)*D/E) = 1*( 1+ (1-40%)*0.35/0.65) = 1.32
3. Beta Levered BetaL = Betau ( 1+ (1-tax rate)*D/E)
1.15 = Betau *( 1+(1-40%)*0.3/0.7)
Betau = 0.9148 or 0.91
4. for new capital structure D/E=60%/40%
Beta Levered BetaLnew = Betau ( 1+ (1-tax rate)*D/E)
BetaL = 0.9148 * ( 1 +(1-40%)* 0.6/0.4) = 1.738 or 1.74
5. Cost of Equity (Re) = Risk free rate + BetaLnew*(Market Return -Risk free rate) = 3% + 1.74*7% = 0.1518 or 15.18%
6. WACC = (E/V)* Re + (D/V)* Rd*(1-tax rate) = 0.6 * 15.18% + 0.4 * 12% *(1-40%) = 0.11988 or 11.99%
Best of Luck God Bless
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