15) Nico Trading Company must choose its optimal capital structure. Currently, t

Question

15) Nico Trading Company must choose its optimal capital structure. Currently, the firm has a 20 percent debt ratio and the firm expects to generate a dividend next year of $5.44 per share. Dividends are expected to remain at this level indefinitely. Stock- holders currently require a 12.1 percent return on their investment. Nico is consider- ing changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will increase its expected dividend to $5.82 per share. Again, dividends are expected to remain at this new level indefi- nitely. However, because of the added risk, the required return demanded by stock holders will increase to 12.6 percent. Based on this information, should Nico make the change? a. Yes b. No c. It’s irrelevant d. Not enough information

****Note**** The answer is not (d. Not enough information)

Explanation / Answer

We need to find whether the total firm value which is value of equity + value of debt increases?

The the Wacc(weighted average cost of capital=weight of equity*cost of equity+ after tax cost of debt*weight of debt) cannot be determined as the after tax cost of debt is not provided, both before and after the change in capital structure.Is the Wacc increasing or decreasing to determine whether the change in in capital structure is optimal.If Wacc decreasing then value increases for firm then its yes optimal, if Wacc increasing then value decreases for firm then its not optimal.

Also after taking into account the cost of financial distress that results from the additional debt issued the firm value=value of equity + value of debt -cost of financial distress,there is no information on cost of financial distress even if value of equity + value of debt increases the cost of financial distress is unknown and cant be concluded whether the value increases for firm or value decreases for firm.

Therefore the right answer is d. Not enough information.

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