6. Determining the optimal capital structure Aa Aa E Understanding the optimal capital structure Review this situation: Universal Exports Inc. is trying to identify its optimal capital structure. Universal Exports Inc. has gathered the following financial information to help with the analysis. Debt Ratio Equity Ratio 30% 70% 40% 60% 50% 50% 60% 40% 70% 30% re 6.02% 6.75% 7.15% 7.55% 8.24% r s 9.40% 9.750% 10.60% 11.30% 12.80% WACC 9.71% 9.55% 10.02% 10.78% 11.45% Which capital structure shown in the preceding table is Universal Exports Inc.’s optimal capital structure? Debt ratio = 40%, equity ratio = 60% Debt ratio = 60%, equity ratio = 40% Debt ratio = 70%; equity ratio = 30% Debt ratio = 50%; equity ratio = 50% Debt ratio = 30%, equity ratio = 70% Consider this case: Globex Corp. has a capital structure that consists of 35% debt and 65% equity.
The firm’s current beta is 1.25, but management wants to understand Globex Corp.’s market risk without the effect of leverage. If Globex Corp. has a 40% tax rate, what is its unlevered beta? O 0.80 O 0.75 O 0.94 O 0.99 Now consider the case of another company: U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 40%. It currently has a levered beta of 1.25. The risk-free rate is 3%, and the risk premium on the market is 8%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm’s level of debt will cause its before-tax cost of debt to increase to 12%. First, solve for U.S. Robotics Inc.’s unlevered beta. Relever U.S. Robotics Inc.’s beta using the firm’s new capital structure. Use U.S. Robotics Inc.’s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. What will the firm’s weighted average cost of capital (WACC) be if it makes this change in its capital structure? O 12.7% 9.8% 11.5% 7.5%
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