Understanding the optimal capital structure Review this situation: Transworld Co
ID: 2657483 • Letter: U
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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 rd 30% 40% 50% 60% 70%o 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 Transworld Consortium Corp.'s optimal capital structure? Debt ratio-70%; equity ratio-30% Debt ratio-50%; equity ratio-50% Debt ratio-30%; equity ratio-70% Debt ratio-60%; equity ratio-40% 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 70% equity and 30% debt. The firm's cost of debt will be 8%, 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 896, 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 10% 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? 10.6% 8.0% 10.1%Explanation / Answer
1. the optimal capital structure is that where, the firm can mimimize the WACC, using the optimal proportion of debt and equity. The optimal capital structure is 40% debt and 60% equity, which gives us a WACC of 9.55% which is the lowest amongst all the in the table.
the correct option is option 5 .
2. The beta from an all equity firm to a firm with capital structure of 70% equity and 30% debt is:
beta ( 1 + D/E )
levered beta = unlevered beta[1+ ( 1- tax rate)D/E)]
= 1 * 1.27
= 1.27
The beta of the firm is 1.27 as with the introduction of debt, the risk level of the firm increases.
3. unlevered beta is :asset beta = 1.15 /[ (1 + D/E )(1 - tax rate )]
= 1.15 / (1+[ 30/70 )(0.65)]
= 0.8994
levered beta = unlevered beta [1 + (1- tax rate )D/E]
= 0.8994 [ 1 + [0.65* 60/40 )]
= 1.7763
WACC = proportion of debt * cost of debt (1 - tax rate ) + proportion of equity * cost of equity
cost of equity = rf + beta* risk premium
= 2.5 + 8 *1.7763
= 16.71
WACC = 0.6* 0.1*0.65 + 0.4*0.1671
= 0.039 + 0.0668
= 10.58%
= 10.6%
THE CORRECT OPTION IS OPTION A.
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