A firm has established the following cost of debt and equity capital (withbankru
ID: 2704474 • Letter: A
Question
A firm has established the following cost of debt and equity capital (withbankruptcy and agency costs) for various proportions of debit in its capital structures:
Proportions of Debt Cost of Debt Cost od Equity
0.00 ------ 10.0%
0.10 4.0% 10.1
0.20 4.2 10.3
0.30 4.4 10.8
0.40 4.8 11.4
0.50 5.5 12.5
0.60 6.6 14.5
0.07 8.0 18.0
Determine the firm's optimal capital structure, and what is the formula to find this out.
Explanation / Answer
Total cost of capital = debt proportion * cost of debt + (1-debt proportion) * cost of equity
The above formula can be used to find out the optimal capital structure which happens when total cost of capital is minimized
So total cost of capital when debt proportion is:
0.0: 0*0%+(1-0)*10% = 10.00%
0.1: 0.1*4%+(1-0.1)*10.1% = 9.49%
0.2: 0.2*4.2%+(1-0.2)*10.3% = 9.08%
0.3: 0.3*4.4%+(1-0.3)*10.8% = 8.88%
0.4: 0.4*4.8%+(1-0.4)*11.4% = 8.76%
0.5: 0.5*5.5%+(1-0.5)*12.5% = 9.00%
0.6: 0.6*6.6%+(1-0.6)*14.5% = 9.76%
0.7: 0.7*8%+(1-0.7)*18% = 11.00%
So the most optimal capital structure is when we have debt proportion as 0.4 of total capital, and this leads to total cost of capital being 8.76%.
Hope this helped ! Let me know in case of any queries.
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