Captial Stucture Bigbee Company currently has no debt; it is 100% equity finance
ID: 2755919 • Letter: C
Question
Captial Stucture
Bigbee Company currently has no debt; it is 100% equity financed. With its current capital structure, the stock’s beta is 1.5. The company is looking to take on some debt to buy back some stock, but management is unsure of how much debt to issue. You have been asked to calculate the optimal capital structure.
The company is experiencing zero growth, and that will continue for the foreseeable future; therefore, there is no immediate need to retain any earnings. All of its earnings are given out in dividends. The company’s tax rat is 40%. The risk free rate is 6% and the market risk premium is 4%.
Investment Bankers have determined that the company would owe the following yield to maturity rates given various capital structures: For the same capital structure scenarios, the company has calculated expected EPS 0% debt 10% debt 20% debt 30% debt 40% debt 50% debt 60% debt 0% 8% 8.3% 9.0% 10% 12% 15% 0% debt 10% debt 20% debt 30% debt 40% debt 50% debt 60% debt $2.40 $2.56 $2.75 $2.97 $3.20 $3.36 $3.30Explanation / Answer
SOLUTION :
Ke = Rf + beta*Risk premium
Ke=cost of equity
Rf = Risk free rate
.06+1.5*.04
Ke=cost of equity
0.12
WACC= Kd(1-t)*Wd + Ke * We
Current WACC= ke=12%
(as 100% equity financed)
Kd = cost of debt
WACC under different scenario
Debt
equity
cost of debt (Kd)
cost of debt after tax
WACC
0
1
0
0
12.00%
0.1
0.9
0.08
0.048
11.28%
0.2
0.8
0.083
0.0498
10.60%
0.3
0.7
0.09
0.054
10.02%
0.4
0.6
0.1
0.06
9.60%
0.5
0.5
0.12
0.072
9.60%
0.6
0.4
0.15
0.09
10.20%
Hence optimal capital structure is 50% debt and equity as It has lowest WACC and highest expected EPS.
Ke = Rf + beta*Risk premium
Ke=cost of equity
Rf = Risk free rate
.06+1.5*.04
Ke=cost of equity
0.12
WACC= Kd(1-t)*Wd + Ke * We
Current WACC= ke=12%
(as 100% equity financed)
Kd = cost of debt
WACC under different scenario
Debt
equity
cost of debt (Kd)
cost of debt after tax
WACC
0
1
0
0
12.00%
0.1
0.9
0.08
0.048
11.28%
0.2
0.8
0.083
0.0498
10.60%
0.3
0.7
0.09
0.054
10.02%
0.4
0.6
0.1
0.06
9.60%
0.5
0.5
0.12
0.072
9.60%
0.6
0.4
0.15
0.09
10.20%
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