Dick & Jane's Children's Books has asked you to help it determine its optimal capital structure. The procedure it is using is to calculate the total value of the company with different blends of debt and equity financing in use. The blend that produces the highest value of the firm will be the blend selected. Assume that Dick & Jane's is zero-growth and it pays all its net income in dividends each year Sales this year are expected to be $800,000 and operating costs are expected to be $600,000. The company's effective tax rate is 40%.
a. If Dick & Jane's uses all equity financing and no debt its cost of equity (Rs) will be 10%. Under these conditions, what is the total value of the company?
b. If Dick & Jane's uses $200,000 in debt financing it can borrow the money at an interest rate of 4%, but it's cost of equity (Rs) will rise to 11%. Under these conditions, what is the total value of the company?
c. If Dick & Jane's uses $400,000 in debt financing it can borrow the money at an interest rate of 6%, but it's cost of equity (Rs) will rise to 13%. Under these conditions, what is the total value of the company?
d. If the capital structures in parts a, b, and c above are the only alternatives available, which blend is optimal for Dick & Jane's Children's Books?