Question: A firm that is financed solely through equity considers changing its capital structure to introduce financial leverage. To achieve this, the firm would issue debt and use the proceeds to repurchase some of its outstanding shares at their current market price of $50 per share. There are currently 20,000 shares outstanding. Earnings before interest and taxes of $300,000 per year are expected to remain constant and all net earnings are paid out in dividends. The firm can issue debt at an interest rate of 12 percent, and the corporate tax rate is 40 percent. Three alternative amounts of debt are under consideration, and the returns that shareholders demand in each case to compensate for the added financial risk are given as follows:
Amount of debt 0 $200,000 $400,000
Required return on equity 18% 20% 25%
(a) What is the optimal amount of debt to take on?
(b) Show that, at the optimal capital structure, the firm simultaneously minimizes the weighted average cost of capital and maximizes both the total value of the firm and the price of the outstanding shares.
(c) The required return for the unlevered firm remains at 18 percent. How would the required return on equity have to increase for the various amounts of debt under consideration if the weighted average cost of capital is to remain constant regardless of leverage?