Review the following situation: Transworld Consortium Corp. is trying to identif

Question

Review the following 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.

Which capital structure shown in the preceding table is Transworld Consortium Corp.’s optimal capital structure?

Debt ratio = 50%; equity ratio = 50%

Debt ratio = 60%; equity ratio = 40%

Debt ratio = 40%; equity ratio = 60%

Debt ratio = 70%; equity ratio = 30%

Debt ratio = 30%; equity ratio = 70%

Consider this case:

Globex Corp. currently has a capital structure 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 3%, the market risk premium is 8%, and Globex Corp.’s beta is 1.10.

If the firm’s tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same? (0.8, 0.72, 0.92, 0.64)  

Debt Ratio (%) Equity Ratio (%) EPS DPS Stock Price 30 70 1.55 0.34 22.35 40 60 1.67 0.45 24.56 50 50 1.72 0.51 25.78 60 40 1.78 0.57 27.75 70 30 1.84 0.62 26.42

Explanation / Answer

Debt ratio = 40%; equity ratio = 60%

beta of an all equity firm = 1.10/(1 + 0.4*0.55/0.6)

beta of an all equity firm = 0.8

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