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4. Determining the optimal capital structure

Understanding the optimal capital structure

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%	70%	1.25	0.55	36.25
40%	60%	1.40	0.60	37.75
50%	50%	1.60	0.65	39.50
60%	40%	1.85	0.75	38.75
70%	30%	1.75	0.70	38.25

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

Debt ratio = 40%; equity ratio = 60%

Debt ratio = 60%; equity ratio = 40%

Debt ratio = 50%; equity ratio = 50%

Debt ratio = 70%; equity ratio = 30%

Debt ratio = 30%; equity ratio = 70%

Consider this case:

Globo-Chem Co. has a capital structure that consists of 30% debt and 70% equity. The firms 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 25% tax rate, what is its unlevered beta?

0.90

1.05

0.81

0.95

Now consider the case of another company:

US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 8%, and its tax rate is 25%. It currently has a levered beta of 1.25. The risk-free rate is 3%, and the risk premium on the market is 7.5%. US Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firms level of debt will cause its before-tax cost of debt to increase to 10%.

First, solve for US Robotics Inc.s unlevered beta.

Use US Robotics Inc.s unlevered beta to solve for the firms levered beta with the new capital structure.

Use US 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 firms weighted average cost of capital (WACC) be if it makes this change in its capital structure?

8.85%

11.80%

10.03%

7.67%

Answer & Explanation Solved by verified expert

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