Review this situation: Transworld Consortium Corp. is trying to identify its opt

Question

Review this situation: Transworld Consortium Corp. is trying to identify its optimal capital structure. Transworld Consortium Corp. has gathered the following financial information to help with the analysis. Debt Ratio Equity Ratio EPS DPS Stock Price 30% 40% 50 60% 70% 70% 60% 50% 40% 30% 1.25 0.55 36.25 1.40 0.60 37.75 1.60 0.65 39.50 1.85 0.7538.75 1.75 0.70 38.25 which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure? O Debt ratio = 40%, equity ratio 60% Debt ratio = 60%, equity ratio-40% Debt ratio = 70%, equity ratio-30% o Debt ratio = 50%, equity ratio = 50% Debt ratio = 30%, equity ratio 70% Consider this case Globex Corp. currently has a capital st cture consisting of 40% debt and 60% equity. However, Globex Corp's CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 2.5%, the market risk premium is 7%, and Globex Corp.'s beta is 1.15. If the firm's tax rate is 35%, what will be the beta of an all-equity firm if its operations were exactly the same? Now consider the case of anather company: US. Robotics Inc. has a current capital st cture of 30% debt and 70% equity. Its current before-tax cost of debt is 8%, and its tax rate is 35%. It currently has a levered beta of 1.15. The risk-free rate is 2.5%, and the risk premium on the market is 7%. US. Robotics Inc. is oonsidering changing its capital st cture to 60% debt and 40% equity Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 10%. First, solve for U.s. Robotics Inc.'s unlevered beta. Relever U.S. Robotics Inc.'s beta using the firm's new capital structure. Use U.S. Robotics Inc.'s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. What will the firm's weighted average cost of capital (WACC) be if it makes this change in its capital structure? 9.9% 10.9% 8.4% 5.9%

Explanation / Answer

1.
Optimal capital structure is where stock price is maximized..This occurs at Debt ratio of 50%
Option D
2.
Unlevered beta=levered beta/(1+(1-tax rate)*Debt/Equity)=1.15/(1+0.65*0.4/0.6)=0.802326
3.
Unlevered beta=1.15/(1+0.65*0.3/0.7)=0.899441
Relevered beta=0.899441*(1+0.65*0.6/0.4)=1.776396
4.
cost of equity=risk free+beta*market risk premium=2.5%+1.776396*7%=14.9348%
5.
WACC=0.6*10%*(1-35%)+0.4*14.9348%=9.9%

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