OPTIMAL CAPITAL STRUCTURE Compugates Holdings is trying to deter- mine its optimal capital structure, which now consists of only common equity. The firm will add debt to its capital structure if it minimizes its WACC, but the firm has no plans to use preferred stock in its capital struc- ture. In addition, the firm's size will remain the same, so funds obtained from debt issued will be used to repurchase stock. The percentage of shares repurchased will be equal to the percentage of debt added to the firm's capital structure. (In other words, if the firm's debt-to-capital ratio increases from 0 to 25%, then 25% of the shares outstanding will be repurchased.) Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm's debt cost at different debt levels: ST-3
OPTIMAL CAPITAL STRUCTURE Compugates Holdings is trying to deter- mine its optimal capital structure, which now consists of only common equity. The firm will add debt to its capital structure if it minimizes its WACC, but the firm has no plans to use preferred stock in its capital struc- ture. In addition, the firm's size will remain the same, so funds obtained from debt issued will be used to repurchase stock. The percentage of shares repurchased will be equal to the percentage of debt added to the firm's capital structure. (In other words, if the firm's debt-to-capital ratio increases from 0 to 25%, then 25% of the shares outstanding will be repurchased.) Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm's debt cost at different debt levels: ST-3
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
Problem 1PS
Related questions
Concept explainers
Cost of Debt, Cost of Preferred Stock
This article deals with the estimation of the value of capital and its components. we'll find out how to estimate the value of debt, the value of preferred shares , and therefore the cost of common shares . we will also determine the way to compute the load of every cost of the capital component then they're going to estimate the general cost of capital. The cost of capital refers to the return rate that an organization gives to its investors. If an organization doesn’t provide enough return, economic process will decrease the costs of their stock and bonds to revive the balance. A firm’s long-run and short-run financial decisions are linked to every other by the assistance of the firm’s cost of capital.
Cost of Common Stock
Common stock is a type of security/instrument issued to Equity shareholders of the Company. These are commonly known as equity shares in India. It is also called ‘Common equity
Question
Capital structure and leverage
![Capital Structure, Dividend Policy,
Before- Tax
Cost of Debt
Debt- to-
Equity-
to-Capital
Ratio (w)
Equity Ratio
(D/E)
Debt- to-
Capital Ratio
(w.)
Bond Rating
(r)
AA
5.0%
1.00
0.0000
0.00
A
6.0
0.75
0.3333
0.25
1.0000
BBB
8.3
0.50
0.50
0.75
0.25
3.0000
BB
11.0
The firm has total capital of $5 million and 200,000 shares of common
stock outstanding. Its EBIT is $500,000 and will not change if debt, at any
of the levels shown in the table above, is added to the firm's capital struc-
ture. Compugates uses the CAPM to estimate its cost of common equity, r.
It estimates that the risk-free rate is 3.5%, the market risk premium is 4.5%,
and its tax rate is 35%. Compugates' current beta, which is b,, because it
has no debt, is 1.25.
a. Calculate the firm's interest expense, net income, shares outstanding,
and EPS for each of the capital structures shown in the table above.
b. At what capital structure is EPS maximized, and what is the firm's
EPS at this capital structure?
Calculate the after-tax cost of debt [r.(1- T)], beta (b, ), cost of equity (r),
and WACC for each of the capital structures shown in the table above.
d. Considering only the capital structures shown, at what capital
structure is WACC minimized and what is the WACC at this capital
С.
structure?
e. At what capital structure does the firm maximize shareholder value?
Is this the same capital structure selected in parts b and d? Explain
why it is, or why it isn't the same.
E As an analyst, what is your recommendation to the firm's manage-
ment regarding Compugates' capital structure?](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2F7c335ddc-9ead-4b78-a500-1a1951db3036%2Ffcaaaa45-8395-48d1-8074-9d90c5170840%2Fht6pxv_processed.jpeg&w=3840&q=75)
Transcribed Image Text:Capital Structure, Dividend Policy,
Before- Tax
Cost of Debt
Debt- to-
Equity-
to-Capital
Ratio (w)
Equity Ratio
(D/E)
Debt- to-
Capital Ratio
(w.)
Bond Rating
(r)
AA
5.0%
1.00
0.0000
0.00
A
6.0
0.75
0.3333
0.25
1.0000
BBB
8.3
0.50
0.50
0.75
0.25
3.0000
BB
11.0
The firm has total capital of $5 million and 200,000 shares of common
stock outstanding. Its EBIT is $500,000 and will not change if debt, at any
of the levels shown in the table above, is added to the firm's capital struc-
ture. Compugates uses the CAPM to estimate its cost of common equity, r.
It estimates that the risk-free rate is 3.5%, the market risk premium is 4.5%,
and its tax rate is 35%. Compugates' current beta, which is b,, because it
has no debt, is 1.25.
a. Calculate the firm's interest expense, net income, shares outstanding,
and EPS for each of the capital structures shown in the table above.
b. At what capital structure is EPS maximized, and what is the firm's
EPS at this capital structure?
Calculate the after-tax cost of debt [r.(1- T)], beta (b, ), cost of equity (r),
and WACC for each of the capital structures shown in the table above.
d. Considering only the capital structures shown, at what capital
structure is WACC minimized and what is the WACC at this capital
С.
structure?
e. At what capital structure does the firm maximize shareholder value?
Is this the same capital structure selected in parts b and d? Explain
why it is, or why it isn't the same.
E As an analyst, what is your recommendation to the firm's manage-
ment regarding Compugates' capital structure?
Transcribed Image Text:OPTIMAL CAPITAL STRUCTURE Compugates Holdings is trying to deter-
mine its optimal capital structure, which now consists of only common
equity. The firm will add debt to its capital structure if it minimizes its
WACC, but the firm has no plans to use preferred stock in its capital struc-
ture. In addition, the firm's size will remain the same, so funds obtained
from debt issued will be used to repurchase stock. The percentage of
shares repurchased will be equal to the percentage of debt added to
the firm's capital structure. (In other words, if the firm's debt-to-capital
ratio increases from 0 to 25%, then 25% of the shares outstanding will be
repurchased.)
Its treasury staff has consulted with investment bankers. On the basis
of those discussions, the staff has created the following table showing the
firm's debt cost at different debt levels:
ST-3
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