Elliott is trying to determine it’s optimal capital structure. The company’s cap

Question

Elliott is trying to determine it’s optimal capital structure. The company’s capital structure consists of debt and common stock. The company’s investment bankers have given the following estimates for Rd.

Percent financed with debt

Bond rating

Before tax cost of debt

0.00

AAA

7.0%

0.20

AA

8.0%

0.40

A

10.0%

0.60

BBB

12.0%

0.80

BB

15.0%

Company uses CAPM to estimate it’s cost of equity. The risk free rate is 5% and the market risk premium is 6%. Elliott estimates that if it had no debt, it’s beta would be 1.2. Company’s tax rate is 40% and growth rate is zero. The company estimates it’s free cash flow to be 30 mn.

On the basis this information, what is the company’s optimal capital structure and what is the firm’s cost of capital at this optimal capital structure?

Guidelines:

·       Students are required to show all the calculations.

·       Calculations should be neatly categorized.

·       Results should be in a tabular form.

·       After calculation, students are required to point out the optimal capital structure and the reason for choosing this.

Percent financed with debt

Bond rating

Before tax cost of debt

0.00

AAA

7.0%

0.20

AA

8.0%

0.40

A

10.0%

0.60

BBB

12.0%

0.80

BB

15.0%

Explanation / Answer

Debt % Equity % Before tax cost of debt After tax cost of debt Equity beta Cost of equity as per CAPM WACC Value of the company                         ($ million) 0.0 1.0 7.0 4.2 1.20 12.20 12.200 245.90 0.2 0.8 8.0 4.8 1.38 13.28 11.584 258.98 0.4 0.6 10.0 6.0 1.68 15.08 11.448 262.05 0.6 0.4 12.0 7.2 2.28 18.68 11.792 254.41 0.8 0.2 15.0 9.0 4.08 29.48 13.096 229.08 Calculations: After tax cost of debt = Before tax cost of debt*(1-t); for 0% debt, after tax cost of debt = 7*(1-0.40) = 4.2% Levered equity beta = Unlevered beta*[1+(1-t)*D/E]; for 20% debt, equity beta = 1.2*(1+0.60*0.2/0.8) = 1.38 Cost of equity as per CAPM = risk free rate+beta*market risk premium; for 20% debt, cost of equity = 5+1.38*6 = 13.28% WACC for debt 20% = 4.8*0.20+13.28*0.80 = 11.584% Value of the company is the PV of the zero growth FCF; for debt % 20% it is 30/0.11584 = $258.98 mn THE COMPANY'S OPTIMAL CAPITAL STRUCTURE IS THAT CS FOR WHICH THE VALUE OF THE COMPANY IS THE MAXIMUM. THE MAXIMUM VALUE OF THE COMPANY IS $262.05 MN AT 40% DEBT, WHICH IS ITS OPTIMAL CAPITAL STRUCTURE. THE COST OF CAPITAL FOR THIS OPTIMAL STRUCTURE = 11.448%, WHICH IS THE LOWEST WACC.

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