Understanding the optimal capital structure Review this situation: Universal Exp
ID: 1171537 • Letter: U
Question
Understanding the optimal capital structure 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. Debt Ratio Equity Ratio rd 30% 40% 50% 60% 70% 70% 60% 50% 40% 30% 6.02% 6.75% 7.15% 7.55% 8.24% 9.40% 9.750% 10.60% 11.30% 12.80% WACC 9.71% 9.55% 10.02% 10.78% 11.45% Which capital structure shown in the preceding table is Universal Exports Inc.'s optimal capital structure? O Debt ratio-30%; equity ratio-70% Debt ratio-60%; equity ratio-40% Debt ratio-70%; equity ratio-30% o Debt ratio-50%; equity ratio-50% Debt ratio-40%; equity ratio 60% Consider this case Globo-Chem Co. is an all-equity firm, and it has a beta of 1, It is considering changing its capital structure to 60% equity and 40% debt. The firm's cost of debt will be 10%, and it will face a tax rate of 35% What will Globo-Chem Co.'s beta be if it decides to make this change in its capital structure? Now consider the case of another company U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 1096, 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 8%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity, increasing the firm's level of debt will cause its before-tax cost of debt to increase to 12%. 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? 11.4% 6.8% 8.6% 9.1% oExplanation / Answer
Answer to Question 1.
Debt Ratio = 40%; Equity Ratio = 60%
Optimal Capital structure is the combination of Debt and Equity, which will minimise firm’s Cost of Capital i.e. WACC.
The minimum cost of capital is 9.55% with 60% of Equity and 40% of Debt.
Therefore, Optimal Capital Structure is 40% of Debt and 60% of Equity.
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