Understanding the optimal capital structure Review this situation: Transworld Co
ID: 2792850 • Letter: U
Question
Understanding the optimal capital structure Review this situation: Transworld Consortium Corp. is trying to identify its optimal capital structure. Transworld Consortium Corp. has gathered the following financial information to help with the analysis Debt Ratio Equity Ratio EPS DPS Stock Price 30% 40% 50% 60% 70% 70% 60% 50% 40% 30% 1.25 0.55 1.40 0.60 1.60 0.65 39.50 1.85 0.75 1.75 0.70 36.25 37.75 38.75 38.25 Which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure? Debt ratio = 40%; equity ratio-60% O Debt ratio 50%; equity ratio 50% O Debt ratio = 70%; equity ratio = 30% Debt ratio = 60%; equity ratio = 40% Debt ratio = 30%; equity ratio = 70%Explanation / Answer
Optimal Capital structure is the debt ratio where Stock Price is maximized
hence, Debt ratio=50% and equity ratio=50% for optimal capital strucutre
Levered beta=unlevered beta*(1+(1-tax rate)*Debt/Equity)=1*(1+(1-35%)*0.4/0.6)=1.433
US robotics unlevered beta=levered beta/(1+(1-tax rate)*Debt/Equity)=1.15/(1+(1-35%)*0.3/0.7)=0.899441
Using new capital strucutre, beta=unlevered beta*(1+(1-tax rate)*Debt/Equity)=0.899441*(1+(1-35%)*0.6/0.4)=1.776396
Cost of equity=risk free+beta*market risk premium=3%+1.776396*7.5%=16.323%
WACC=proportion of debt*cost of debt*(1-tax rate)+proportion of equity*cost of equity=0.6*8%*(1-35%)+0.4*16.323%=9.6492%
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