Optimal capital structure Jackson Trucking Company is in the process of setting

Question

Optimal capital structure

Jackson Trucking Company is in the process of setting its target capital structure. The CFO believes the optimal debt-to-capital ratio is somewhere between 20% and 50%, and her staff has compiled the following projections for EPS and the stock price at various debt levels:

Assuming that the firm uses only debt and common equity, what is Jackson's optimal capital structure? Round your answers to two decimal places.

a.) % debt
b.) % equity

At what debt ratio is the company's WACC minimized? Round your answer to two decimal places.

c.) %

Debt/Capital Ratio Projected EPS Projected Stock Price             20% $3.20         $33.50                         30 3.60         35.75                         40 3.75         36.00                         50 3.60         32.00            

Explanation / Answer

A company achieves optimal capital structure when its WACC (weighted average cost of capital) is minimized and the company's stock price is maximized. In the given case, the company's stock price is maximum at 40% debt ratio. Here, the stock price of $36, which is higher as compared to other debt/capital ratios. Therefore, the optimal proportion of debt and equity would be:

a) Debt = 40% (indicates that firm's total capital structure comprises of 40% debt)

b) Equity = 1-40% = 60% (indicates that firm's total capital structure comprises of 60% equity)

____________

Tabular Representation:

__________________________

c) The company's WACC will be minimum at the same level of 40% debt ratio as stated above.

a) 40% debt b) 60% equity

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