Hades Furnace has a current, optimal capital structure of 20% debt and 80% equit

Question

Hades Furnace has a current, optimal capital structure of 20% debt and 80% equity. Hades can borrow up to $20 million at a 9% rate, an additional $10 million at an 11% rate, and any additional funds at a rate of 13%. The firm expects to retain $60 million of its earnings and can raise additional funds by issuing new common stock. The firm’s common stock currently trades at $30.50. The last dividend paid was $3.20 and dividends are expected to grow at a 4% rate. If Hades issues new common stock, it will be priced at $27.50 per share and the investment banker’s fee will be $0.50 per share. If Hades’ marginal tax rate is 40%, determine its debt breakpoints.

Question options:

a) $20m and $30m

b) $20m and $50m

c) $100m and $150m

d) There is not enough information to answer the question

Explanation / Answer

It is given that hades can borrow $20 million debt at 9% and addition $10 million at 11% and any additional funds at 13%

Optimal Capital Structure is given as 80% equity and 20% debt

So whenever firm needs financing it will raise 80% from equity and 20% from debt

Now firm is retaining $ 60 million of its earnings andcan rise additional funds by issuing common stock

Debt breakpoints would be the point where interest rate of debt will change

First breakpoint will come when firm will raise $20 million of debt and needs additional funding

If debt id $20 million then total capital of firm is 20/0.2 = $100 million

So first breakpoint will come at $100 million as till now firm can raise debt at 9%

Now firm can raise additional $10 million at 11% i.e. till the point where firms total debt = 20+10 = $30 million

If firms debt is 30 million then its total capital = 30/0.2 = $150 million

So second breakpoint will come at $150 million as till now firm can raise debt at 11%

After that firm can raise all funds at 13%

So there will be only two brakpoints

Therefore, answer is option 'c' i.e. $100m and $150m

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