ABC is trying to determine its optimal capital structure. The Company’s capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
D/V Rating Cost of Debt
0.1 AA 7.00%
0.2 A 7.2
0.3 A 8
0.4 BB 8.8
0.5 B 9.6
The company’s tax rate is 40 percent. The company uses the CAPM model to estimate its cost of equity. The risk-free rate is estimated to be 5 percent and the equity market risk premium is 6 percent. Company’s estimate of its asset beta is 1.05
Company’s operating profit (EBIT) is expected to be $2,000,000 in the foreseeable future. Assume no net investment in fixed assets (only depreciated assets are replenished) and working capital. ABC currently has 1,000,000 outstanding shares.
1) On the basis of this information, what are the unlevered company’s market value and its share price?
2) Assume that company is planning to recapitalize to reach an optimal capital structure. Assuming that company will use the new debt to repurchase its shares, for each D/V level determine
a) Market Value of Firm
b) Cost of equity
c) Share Price after the recapitalization announcement
d) Number of shares outstanding following the stock repurchase
e) Market Value of Equity
f) WACC and Optimal Capital Structure
g) At what level of debt, company’s WACC is minimized? Explain.
3) Reflect on what you have learned about firm’s choice of capital structure in the light of the question above. What other considerations are given in determining capital structure in practice that is not captured in the context of the current question?