The T. Boom Pickens Corporation has a $1 million capital structure and always maintains this book value amount. Pickens currently earns $250,000 per year before taxes of 50 percent, has an all-equity capital structure of 100,000 shares, and pays out all earnings in dividends. The company is considering issuing debt in order to retire common stock. The cost of the debt and the resulting price per share of the common stock at various levels of debt are given in the following table. It is assumed that the new capital structure would be reached all at once by purchasing common stock at the current price of $10 per share. In other words, the table below is a schedule of alternative conditions at a single point in time.
|
AMOUNT OF DEBT
|
AVERAGE PRE-TAX
COST OF DEBT
|
RESULTING PRICE PER SHARE
OF COMMON STOCK
|
|
$ 0
|
-
|
$10.00
|
|
100,000
|
10.0%
|
10.00
|
|
200,000
|
10.0
|
10.50
|
|
300,000
|
10.5
|
10.75
|
|
400,000
|
11.0
|
11.00
|
|
500,000
|
12.0
|
10.50
|
|
600,000
|
14.0
|
9.50
|
a. By observation, what do you think is the optimal capital structure (the capital structure that minimizes the firm's overall cost of capital)? Why?
b. Construct a graph that relates after-tax capital costs (ke, ki, and ko) to financial leverage ratios (B/S) based on the data given above.
c. Are your feelings in Part (a) confirmed?