Understanding the optimal capital structure Review this situation: Transworld Co

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% 5096 60% 70% 7096 1.25 0.55 36.25 60% 1.40 0.60 37.75 50% 1.600.65 39.50 40% 1.85 0.75 38.75 30% 1.75 0.70 38.25 Which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure? Debt ratio = 40%; equity ratio = 60% Debt ratio-30%; equity ratio-70% Debt ratio-60%; equity ratio-40% Debt ratio-70%; equity ratio 30% Debt ratio-50%; equity ratio 50% Consider this case: Globex Corp. is an all-equity firm, and it has a beta 1 . It is considering changing its capital structure to 70% equity and 30% debt. The firm's cost of debt will be 8%, and it will face a tax rate of 35%. What will Globex Corp.'s beta be if it decides to make this change in its capital structure?

Explanation / Answer

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1) Debt ratio = 50%; equity ratio = 50%. The Share price is the highest for this capital structure. 2) Levered Beta of Globex Corp = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity))) = 1+(0.65*3/7) = 1.28 3) Unlevering of existing levered beta of U S Robotics = 1.25/(1+0.65*3/7) = 0.98 Relevering of the unlevered beta = 0.98*(1+0.65*0.6/0.4) = 1.94 Cost of equity as per new capital structure = 3.5+1.94*7.5 = 18.05 WACC = 18.05*0.40+10*0.65*0.60 = 11.12 4) The optiimal capital structure is …….. That decreases the WACC and increases the ……………… 5) Higher debt levels increase the firm's risk. Consequently,……………to increase. 6) Axis Chemical company ……………. No. P/E has also to be considered.

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