Given the following choices, what is the optimal capital structure for Chip Co.?
ID: 2823224 • Letter: G
Question
Given the following choices, what is the optimal capital structure for Chip Co.? (Assume that the company's growth rate is 2%.)
Dividends
Cost of
Debt Ratio
Per Share
Equity (r s)
0%
$5.50
11.5%
25
6.00
12.0
40
6.50
13.0
50
7.00
14.0
75
7.50
15.0
0% debt; 100% equity
25% debt; 75% equity
40% debt; 60% equity
50% debt; 50% equity
75% debt; 25% equity
Dividends
Cost of
Debt Ratio
Per Share
Equity (r s)
0%
$5.50
11.5%
25
6.00
12.0
40
6.50
13.0
50
7.00
14.0
75
7.50
15.0
Explanation / Answer
Optimal capital structure is where the share price is maximum.
Cost of Equity Dividend/( Cost of Equity - Growth)
1. For 0% debt Ratio Price of share = 5.5/(11.5% - 2%) = 57.89
2. For 25% debt Ratio Price of share = 6/(12% - 2%) =60.00
3. For 40% debt Ratio Price of share = 6.5/(13% - 2%) = 59.09
4. For 50% debt Ratio Price of share = 7.0/(14% - 2%) = 58.33
5. For 75% debt Ratio Price of share = 7.5/(15% - 2%) = 57.69
25% debt; 75% equity gives optimal capital structure as price = 60.00
Best of Luck. God Bless
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