Brew claws company has collected the following data concerning its capital struc

Question

Brew claws company has collected the following data concerning its capital structure, expected earnings per share, and required return.

1. Using the capitalized earnings method (EPS/rs), compute the estimated share values associated with each of the capital structures.

2. Select the optimal capital structure on the basis of:

A. Maximization of expected earnings per share.       B. Maximization of share value.

3. Which capital structure do you recommend? Why?

Capital Structure (debt ratio) Expected Earnings per share Investor required return (Rs) 0.00% $6.24 13% 10% $7.80 15% 20% $9.60 16% 30% $10.88 17% 40% $11.02 19% 50% $10.00 20% 60% $8.80 22%

Explanation / Answer

1) Estimated share values associated with each of the capital structures is as below :

2)  The optimal capital structure on the basis of maximization of expected earnings per share = debt ratio of 40% and equity ratio of 60%

The optimal capital structure on the basis of maximization of share value = 30% debt and 70% equity .

3) The capital structure recommended by me is 30% debt and 70% equity . Maximization of EPS does not ensure owner wealth maximization and maximization of share value at a capital structure of 30% debt and 70% equity is the optimal capital structure .

Capital structure (debt ratio) Expected earnings per share Investor required return Average price per share = (Expected earnings per share) / (Investor required return) 0% 6.24 13% 6.24/0.13 = $ 48 10% 7.8 15% 7.8/0.15 = $ 52 20% 9.6 16% 9.6/0.16 = $ 60 30% 10.88 17% 10.88/.17 = $ 64 40% 11.02 19% 11.02/0.19 = $58 50% 10 20% 10/0.20 = $ 50 60% 8.8 22% 8.8/0.22 = $ 40

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