ACB Inc. is examining its capital structure with the intent of arriving at an op

Question

ACB Inc. is examining its capital structure with the intent of arriving at an optimal debt ratio. It currently has no debt and has a beta of 1.3. The T-bill rate is 8% and the T-Bond rate is 9.5%. Your research indicates that the debt rating will as follows at different debt levels:

D/(D+E) Rating Interest rate

0% AAA 10%

10% AA 10.5%

20% A 11%

30% BBB 12%

40% BB 13%

50% B 14%

60% CCC 16%

70% CC 18%

80% C 20%

90% D 25%

The firm currently has 2 million shares outstanding at $30 per share. (Tax rate = 40%)

a. What is the firm's optimal debt ratio?

b. Assuming that the firm restructure and purchases stock with debt, what will the value pf the stock be after the restructuring?

Explanation / Answer

Optimal level 30:70 where WACC is low

Value of common stock 2million shares *.70* $30 = 42 Million

D/(D+E) Interest rate Beta Cost of equity Weight Weighted Cost Of Equity Cost of debt Weighted Cost Of Debt WACC 0% 10% 1.30 0.0995 100% 10% 6% 0 9.95% 10% 10.50% 1.39 0.1008 90% 9% 6% 0.0063 9.70% 20% 11% 1.50 0.1024 80% 8% 7% 0.0132 9.51% 30% 12% 1.63 0.1045 70% 7% 7% 0.0216 9.48% 40% 13% 1.82 0.1073 60% 6% 8% 0.0312 9.56% 50.00% 14.00% 2.08 0.1112 50.00% 5.56% 8.40% 4.20% 9.76% 60% 16% 2.47 0.1171 40% 5% 10% 0.0576 10.44% 70% 18% 3.12 0.1268 30% 4% 11% 0.0756 11.36% 80% 20% 4.42 0.1463 20% 3% 12% 0.096 12.53% 90% 25% 8.32 0.2048 10% 2% 15% 0.135 15.55%

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