Chapter 12, Problem 3PROB

Summary Introduction

Capital Structure of any company is the mix of different levels of debt and equity. An optimal capital structure is the appropriate mix of debt and equity, striking a balance between risk and return to achieve the goal of maximizing the price of the firm’s stock. Therefore, a target proportion of capital structure and cost of each financing can be used to determine the WACC of the company.

Weighted Average Cost of Capital (WACC) is the required rate of return investors would expect from the company. If a company uses a combination of financing alternatives to fund its business, it should calculate an average cost of capital. Various long-term funds include debt, equity and preferred stock. Regardless of the mode of financing for a project, a company’s WACC should be considered in making capital budgeting decisions.

$WACC=w_d\left(r_{dT}\right)+w_{ps}\left(r_{ps}\right)+w_s\left(r_{s}or{r}_e\right)$

Here,

Proportion of debt in the target capital structure “$w_d$”

Proportion of preferred stock in the target capital structure “$w_{ps}$

Proportion of equity in the target capital structure “$w_s$”

After tax cost of debt, preferred stock, retained earnings and new equity is “$r_{dT}$”,“$r_{ps}$”,“$r_s$”and “$r_e$”, respectively.

EPS analysis at a given level of EBIT helps in determining the optimal capital structure of the firm, that is the structure at which the EPS will be the highest.

Firm AB and YZ have $200,000 as assets and $40,000 as EBIT. Both have 5,000 shares outstanding and both have marginal tax rate of 40%. Firm AB has debt to total asset ratio of 40% and pays 7.5% as interest whereas Firm YZ has debt to total asset ratio of 60% and pay 10% as interest.