6. Determining the optimal capital structure Aa Aa Understanding the optimal cap

Question

6. Determining the optimal capital structure Aa Aa Understanding the optimal capital structure Review this situation: Universal Exports Inc. is trying to identify its optimal capital structure. Universal Exports Inc. has gathered the following financial information to help with the analysis Debt Ratio Equity Ratio rd 30% 40% 50% 60% 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 Universal Exports Inc.'s optimal capital structure? Debt ratio = 70%; equity ratio = 30% Debt ratio = 40%; equity ratio = 60% O Debt ratio 60%; equity ratio 40% Debt ratio = 30%; equity ratio = 70% Debt ratio = 50%; equity ratio = 50%

Explanation / Answer

Optimium capital structure is that mix of capital structure which provides the minimum cost of capital(WACC)

Hence Optimum capital structure will be 40% debt , 60% Equity with WACC of 9.55%

Unlevered beta = Levered beta/ 1+D/E (1-t)

Here debt is 30%n Equity is 70% i.e., D/E= 3/7

Unlevered Beta= 1.25/1+{3/7(1-.45)}= 1.25/1.23571= 1.012appx

New D/E = 6/4

Levered beta= unlevered Beta* {1+(D/E)(1-t)}= 1.012*{1+(6/4)(1-0.45)}= 1.012*1.825=1.85 appx

cost of Equity using CAPM= Rf+ Market risk premium* new levered beta

= 3.5+(7.5*1.85)= 17.375%

Kd=I(1-t)= 12(1-0.45)= 6.60%

WACC= 0.6*Kd+0.4*Ke= 0.6*6.60+0.4*17.375= 10.91%

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