Review this situation: Universal Exports Inc. is trying to identify its optimal

Question

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. Which capital structure shown in the preceding table is Universal Exports Inc/s optimal capital structure? Consider this case: Globo-Chem Co. has a capital structure that consists of 40% debt and 60% equity. The firm's current beta is 1.25, but management wants to understand Globo-Chem Co.'s market risk without the effect of leverage. If Globo-Chem Co. has a 35% tax rate, what is its unlevered beta? 0.83 0.91 1.04 0.87

Explanation / Answer

Universal Exports Inc:

The optimal capital structure is the financing mix of debt and equity that balances a firm's risk and expected return and maximizes long-run shareholder wealth. The capital structure that maximizes the stock price also maximizes shareholder wealth. Both Universal Exports Inc.'s earnings per share (EPS) and dividends per share (DPS) are maximized at a debt ratio of 60%, but that is not the same as maximizing long-run shareholder wealth. The firm's optimal capital structure occurs at a debt ratio of 50%, which results in the highest stock price.
So, the 3rd option is correct.

Globo-Chom

Unlevered Beta = Levered Beta / [1 + (1 – Tax)*(Debt/Equity)]

1.25 / [1 + (1 – 35%)*(40%/60%)] = 0.8721

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