9. Determining the optimal capital structureAa AaUnderstanding the optimal capital structureReview this situation: Transworld Consortium Corp. is trying to identify its optimal capital structure. TransworldConsortium Corp. has gathered the following financial information to help with the analysis.Debt Ratio Equity Ratio EPS DPS Stock Price30%70%1.55 0.3422.3540%60%1.67 0.4524.5650%50%1.72 0.5125.7860%40%1.78 0.5727.7570%30%1.84 0.6226.42Which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure?Debt ratio50%; equity ratio50%Debt ratio =30%; equity ratio = 70%Debt ratio70%; equity ratio30%Debt ratio = 40%; equity ratio = 60%Debt ratio60%; equity ratio = 40%Consider this case:Globex Corp. has a capital structure that consists of 30% debt and 70% equity. The firm's current beta is 1.15, butmanagement wants to understand Globex Corp.'s market risk without the effect of leverage.If Globex Corp. has a 35% tax rate, what is its unlevered beta? If Globex Corp. has a 35% tax rate, what is its unlevered beta?0.990.900.721.04Now consider the case of another company:U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is6%, and its tax rate is 35%. It currently has a levered beta of 1.15. The risk-free rate is 2.5%, and the risk premiumon the market is 7%.U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm'slevel of debt will cause its before-tax cost of debt to increase to 8%. Use the Hamada equation to unlever and releverthe beta for the new level of debt. What will the firm's weighted average cost of capital (WACC) be if it makes thischange in its capital structure?Which of the following statements regarding a firm's optimal capital structure are true? Check all that apply.The optimal capital structure maximizes the firm's stock price.The optimal capital structure minimizes the firm's WACC.The optimal capital structure minimizes the firm's cost of debt.The optimal capital structure minimizes the firm's cost of equity.The optimal capital structure maximizes the firm's EPS.

The optimum Capital Structure of a firm is the best mix of debt and equity financing that maximizes a company's Market Value while Minimizing its cost of capital Generally Debt Financing offers the lowest cost of capital Huge amount debt increases the financial risk to shareholders Minimizing the Weighted average cost of capital(wacc) is correct way to optimize for the lowest cost mix of financing In the above table Debt Equity DebtEquity 30% 70% 0.42 40% 60% 0.66 50% 50% 1 60% 40% 1.5 70% 30% 2.33 The most optimum capital structure is Debt 30% and Equity 70% the more debt creates uncertainity in future earnings Beta is a measure of risk and beta of any company indicates its sensitivity towards the market. Unlevered is the volatility of company returns - impact of debt Un levered Beta = Levered Beta1 + (1-Tax Rate)×(Total DebtEquity)Unlevered Beta = 1.151 +(1-0.35)(0.30.7)Unlevered Beta =0.9 The Unleverd Beta of Globex Corp is 0.90 U.S ROBOTICS CASE UN Levered beta = 0.9 Debt = 40% and equity = 60% Tax rate = 35% Levered Beta = Unlevered Beta(1 + (1 -Tax Rate)(DebtEquity) =0.9(1+(1-0.35)(0.40.6) =0.62 So Levered beta with 60% OF debt level is 0.62 Now expected return when debt level is 60% is caluclated using CAPM model Expected rate of return = Risk Free Rate + Risk Premium * Beta = 2.5% + 8%*0.62 =7.46 Hence, if Debt level will 60% the cost of equity will be 7.46% Now,WACC at 60% debt level is caluclated below WACC = (7.46% *40%) + (60% * 8%)*(1-35%) =2.98 +3.12 =6.10% New WACC of Company is 6.10% Optimum Capital Structure is one that minimize WACC and Minimize stock price

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9. Determining the optimal capital structure Aa Aa 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% 70% 1.55 0.34 22.35 40% 60% 1.67 0.45 24.56 50% 50% 1.72 0.51 25.78 60% 40% 1.78 0.57 27.75 70% 30% 1.84 0.62 26.42 Which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure? Debt ratio = 50%; equity ratio = 50% Debt ratio = 30%; equity ratio = 70% Debt ratio = 70%; equity ratio = 30% Debt ratio = 40%; equity ratio = 60% Debt ratio = 60%; equity ratio = 40% Consider this case: Globex Corp. has a capital structure that consists of 30% debt and 70% equity. The firm's current beta is 1.15, but management wants to understand Globex Corp.'s market risk without the effect of leverage. O000O

9. Determining the optimal capital structure Aa Aa 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% 70% 1.55 0.34 22.35 40% 60% 1.67 0.45 24.56 50% 50% 1.72 0.51 25.78 60% 40% 1.78 0.57 27.75 70% 30% 1.84 0.62 26.42 Which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure? Debt ratio = 50%; equity ratio = 50% Debt ratio = 30%; equity ratio = 70% Debt ratio = 70%; equity ratio = 30% Debt ratio = 40%; equity ratio = 60% Debt ratio = 60%; equity ratio = 40% Consider this case: Globex Corp. has a capital structure that consists of 30% debt and 70% equity. The firm's current beta is 1.15, but management wants to understand Globex Corp.'s market risk without the effect of leverage. O000O

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

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Q18
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 30% 40% 50% 60% 70% Equity Ratio Consider this case: 70% 60% 50% 40% 30% Td Ts WACC 7.00% 10.50% 8.61% 7.20% 10.80% 8.21% 7.70% 11.40% 8.01% 8.90% 12.20% 8.08% 10.30% 13.50% 8.38% Which capital structure shown in the preceding table is Universal Exports Inc.'s optimal capital structure? Debt ratio = 40% ; equity ratio = 60% Debt ratio = 30% ; equity ratio = 70% Debt ratio 50 % ; equity ratio = 50% Debt ratio 60%; equity ratio = 40% Debt ratio 70% ; equity ratio= 30%
i Explain how wrong calculation of the cost of capital of a project leads toincorrect choice of a project. ii Explain the superiority of the Security Market Line (SML) approach ascompared to the dividend valuation model. iii A company is faced with the choice of one of two investment opportunities Aand B. The initial cost of each is Rs.200,000 and their estimated cash flows areas follows.Year Cash Flows (Rs.) – A Cash Flows (Rs.)- B1 200,000 40,0002 240,000 60,000Assuming a cost of capital of 7% calculate (year 1: .935; year 2: .873)a. NPVb. The yield rate of each projectc. Say which project you would select
Course : Portfolio Management
Debt Ratio Equity Ratio EPS DPS Stock Price 30% 70% 1.55 0.34 22.35 40% 60% 1.67 0.45 24.56 50% 50% 1.72 0.51 25.78 60% 40% 1.78 0.57 27.75 70% 30% 1.84 0.62 26.42 Which capital structure shown in the preceding table is Universal Exports Inc.’s optimal capital structure? Globex Corp. has a capital structure that consists of 40% debt and 60% equity. The firm’s current beta is 1.10, but management wants to understand Globex Corp.’s market risk without the effect of leverage. If Globex Corp. has a 25% tax rate, what is its unlevered beta?
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 30% 40% 50% 60% 70% Equity Ratio 70% 60% 50% 40% 30% Id 7.00% 7.20% 7.70% 11.40% 8.90% 12.20% 10.30% 13.50% Is WACC 10.50% 8.61% 10.80% 8.21% 8.01% 8.08% 8.38% Which capital structure shown in the preceding table is Universal Exports Inc.'s optimal capital structure? Debt ratio = 70%; equity ratio = 30% Debt ratio 50%; equity ratio = 50% Debt ratio = 30%; equity ratio = 70% Debt ratio = 40%; equity ratio = 60% Debt ratio= 60%; equity ratio = 40%
1. Using capital asset pricing model, compute for the cost of equity with risk-free rate of 4%, market return on 8%, beta of 1.5 and tax rate of 30%. 2. With risk-free rate of 5%, beta of 1.5, market return of 8%, prevailing credit spread (rate applied on debt on top of risk-free rate) of 3%, tax rate of 30% and equity ratio of 30%, compute for the weighted average cost of capital. 3. The appropriate WACC of a company is 8%. With risk-free rate of 4%, market return of 10%, prevailing credit spread of 2%, tax rate of 30% and equity ratio of 40%, compute the beta.
What is the company's cost of debt? a. 9.21%b. 10.31%c. 11.5%d. 7.73% What is the company's cost of equity using the Capital Asset Pricing Model? a. 9.21%b. 10.31%c. 11.5%d. 7.73%
OPTIMAL CAPITAL STRUCTURE Terrell Trucking Company is in the process of setting its target capital structure. The CFO believes that the optimal debt-to-capital ratio is somewhere between 20% and 50%, and her staff has compiled the following projections for EPS and the stock price at various debt levels: Debt/Capital Ratio Projected EPS Projected Stock Price20% $3.10 $34.2530 3.55 36.0040 3.70 35.5050 3.55 34.00Assuming that the firm uses only debt and common equity, what is Terrell’s optimal capital structure? At what debt-to-capital ratio is the company’s WACC minimized?
CHOICES A. Only Statement I is correctB. Only Statement II is falseC. Statements II and III are falseD. Only Statement III is falseE. All statements are correct
Which of the following statements are correct? Preferred equities are separate form common equities Opportunity cost should not be included in the capital budgeting decision Retained earnings are important in calculating the WACC Weights for equity in the WACC calculation are always on book values Cash from net working capital for each year is defined as NWCn- NWCn-1
BIE The Cost of Capital: Weighted Averige cost of capital The firm's target capital structure is the mix of debt, presured stack, and common equity the firm plans to mise funds for future projects. The target proportions of debt, preferred stock, and common equity, along with the cost of these I components, are used to calculate the firm's weighted average cost of capital (WACC). If the firm will not have to issue new common study then the cost of retained earnings is used in the firm's WACC calculation. However, if the firm will I have to issue new common stock, the cost of new common stock should be used in the firm's WALC calculation. Barton Industines expects that its target capital Structure for finds in the future for its raising capital budget will consist of 40% debt, 5% prefence stock, and 55% common equity. Note that the firm's marginal tax rate is 25%. Assume that the firm's cost of debt, rd is 10.0%, the firm's cost of preferred stock, rp is 9.2.%. and the firm's cost of…

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