After discussions with an investment banker about issuing additional debt, your
ID: 2475594 • Letter: A
Question
After discussions with an investment banker about issuing additional debt, your analyst found that the cost of debt (before tax) depends on the amount of debt in the capital structure. Jamnic Digital Automotive’ cost of debt estimates for various levels of debt financing (D/E) were obtained.
The before tax cost of debt (rd) for Jamnic s 5.12%, and the common stock beta is 1.43. The current capital structure (market value) is as follows:
Jamnic Digital Automotive.
Debt $2,450,000
Equity 7,350,000
$9,800,000
Jamnic Digital Automotive uses the firm’s WACC for average risk projects, it adds 2% for high risk projects. For low risk projects it uses the WACC less 2%.
Your analysts also compiled current market information:
Market risk premium (RPm): 4%
Risk-free rate (rRF): 2.25%
Fanning Analytics, Inc.
D/E
Debt/
Capital
(Wd)
rd
Equity
Beta
Equity/
Capital
(We)
rs
WACC
0.00
0.0
n.a.
1.0
0.333
0.25
5.12%
1.43
0.40
7.25%
0.60
8.00%
* Debt/Capital = Debt/(Debt + Equity),
Equity/Capital = Equity/(Debt + Equity).
6. a. (10 points) Complete the table above (show your calculations).
b. (5 points) (Choose the correct response and fill in the blank. )
If our goal is to maximize the value of the firm, the "Optimal Capital Structure" is the choice of debt and equity (D/E) that minimizes_ [maximizes/minimizes] the firm's cost of capital (WACC).
c. (5 points) Based on the information given in the table you completed, should Jamnic Digital Automotive change its capital structure from its current level (D/E = .333)? That is, what is the firm's optimal capital structure?
D/E
Debt/
Capital
(Wd)
rd
Equity
Beta
Equity/
Capital
(We)
rs
WACC
0.00
0.0
n.a.
1.0
0.333
0.25
5.12%
1.43
0.40
7.25%
0.60
8.00%
Explanation / Answer
a)
Complete the table.
b)
Optimal capital structure is debt 0.25 and Equity is 0.75
Debt : Equity = 0.25:0.75
c)
Present capital structure is the optimal capital structure and thus no need of changing the capital structure.
D/E Debt/Capital(Wd) rd Equity Beta Equity/Capital (We) rs WACC 0 0 n.a. 1.43 1 7.97 7.97 2.25+1.43*4 0.333 0.25 5.12% 1.43 0.75 7.97 7.2575 0.333/1.333 (1-Wd) 2.25+1.43*4 5.12*0.25 + 7.97*0.75 0.4 0.28571429 7.25% 1.43 0.71428571 7.97 7.764137 0.4/1.4 (1-Wd) 2.25+1.43*4 7.25*0.2857 + 7.97*0.71428 0.6 0.375 8.00% 1.43 0.625 7.97 7.98125 0.6/1.6 (1-Wd) 2.25+1.43*4 8*0.375 + 7.97*0.625Related Questions
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