6. Determining the optimal capital structure Aa Aa E Understanding the optimal c

Question

6. Determining the optimal capital structure Aa Aa E Understanding the optimal capital structure Review this situation: Universal Exports Inc. is trying to identify its optimal capital structure. Universal Exports Inc. has gathered the following financial information to help with the analysis. Debt Ratio Equity Ratiord 30% 40% 50% 60% 70% 70% 60% 50% 40% 30% 6.02% 6.75% 7.1596 7.55% 8.24% 9.40% 9.750% 10.60% 11.30% 12.80% WACC 9.71% 9.55% 10.02% 10.78% 11.45% Which capital structure shown in the preceding table is Universal Exports Inc.'s optimal capital structure? Debt ratio-30%; equity ratio 70% 0 Debt ratio +40%; equity ratio 60% Debt ratio-60%; equity ratio-40% Debt ratio-50%; equity ratio-50% O Debt ratio 70%, equity ratio 30%

Explanation / Answer

Universal Exports The optimal capital structure will be the one corresponding to the lowest WACC i.e 9.55 % Therefore optimal structure is the second one debt ratio 40% , equity ratio 60 % 13) Globex Corp levered beta = unlevered beta [1+ (1-tax rate)*(Debt/equity)] = 1*[1+0.55*40/60] = 1.37 US robotics inc levered beta = unlevered beta [1+ (1-tax rate)*(Debt/equity)] 1.10= unlevered beta * [1 +(1-.45)*(30/70)] 1.10 = unlevered beta * 1.235714 unlevered beta = 0.89 For the new capital structure Levered beta = 0.89* [1 +(1-.45)*(60/40)] = 1.62 After tax cost of debt = 10%(1-45%) = 5.5 % with the CAPM model cost of equity = risk free rate + (Beta * market risk premuim) = 3.5 + (1.62*7) = 14.84 % WACC= (0.6*5.5%)+(0.4*14.84%) 0.092 = 9.20%

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