OPTIMAL CAPITAL STRUCTURE

1. D
2. D
3. C
4. B
5. A
6. B
7. D
8. D
9. C
10. C

PROBLEM SOLVING:

PROBLEM A.
1. A table should be made to show the cursory computation of the mean:

A B C D
Structure Price per share Probability Mean
1 P5.20 15% 0.78
2 P5.25 30% 1.575
3 P5.30 45% 2.385
4 P5.35 10% 0.535
Overall Mean 5.275

2. A table should be made to show the cursory computation of the mean:

E F G H
Price per Deviation Deviation Sq. Deviation
share Squared x Probability
E Mean F2 GxC
P5.20 -0.075 0.005625 0.00084375
P5.25 -0.025 0.000625 0.0001875
P5.30 0.025 0.000625 0.00028125
P5.35 0.075 0.005625 0.0005625
Variance 0.001875
Standard 0.0433
Deviation
(Square Root
of Variance)
PROBLEM B.

1. Current Cost of Equity

( )
( )

2. Unlevered Beta
( )( )

( )( )

( )( )

3. New (Levered) Beta (at debt-to-equity ratio of 50%:50%)

( )( )
( )( )

4. New Cost of Equity using New Beta of 1.67 (at equity portion of 50%)
( )
( )

PROBLEM C.

To determine the optimal capital structure, the stock price (P0) must be computed. The
capital structure with the highest stock price is the optimal capital structure.

Debt Dividends Cost of Stock

Ratio per share equity Price
(Div1) (ke) P0
0% P4.50 11.0% P56.25
25% P5.00 12.0% P55.56
40% P5.50 13.0% P55.00
50% P6.00 14.0% P54.55
75% P6.50 15.0% P54.17

P0 =
1. What is the price of the stock if the firm is unlevered? 56.25
2. What is the price of the stock for each level of debt? (Refer to table above)
3. What is the debt ratio at the optimal capital structure? 0%
4. What is the equity ratio at the optimal capital structure? 100%
PROBEM D.

This problem uses a trial-and-error method to determine which capital structure shows
the lowest WACC.

Debt-to- Equity-to- Debt-to-equity Bond Before-

total assets total assets ratio (D/E) rating tax cost
ratio (wd) ratio (wc) of debt
0.10 0.90 0.10/0.90 = 0.11 AA 7.0%
0.20 0.80 0.20/0.80 = 0.25 A 7.2%
0.30 0.70 0.30/0.70 = 0.43 A 8.0%
0.40 0.60 0.40/0.60 = 0.67 BB 8.8%
0.50 0.50 0.50/0.50 = 1.00 B 9.6%

Debt-to- Resulting Resulting Cost of WACC

equity ratio Beta () Equity
(D/E) ( )
=6% + (14%-6%)
0.10/0.90 = 1.28 16.24% 15.04%
0.11
0.20/0.80 = 1.38 17.04% 14.50%
0.25
0.30/0.70 = 1.51 18.08% 14.10%
0.43
0.40/0.60 = 1.68 19.44% 13.78%
0.67
0.50/0.50 = 1.92 21.36% 13.56%
1.00

Beta levered old (at debt to equity of 10%:90%

( )
=6% + (14%-6%)

Beta Unlevered = 1.2:

Unlevered Beta
( )( )

( )( )

( )( )
 New (Levered) Beta (at debt-to-equity ratio of 20%:80%)

( )( )
( )( )

New (Levered) Beta (at debt-to-equity ratio of 30%:70%)

( )( )
( )( )

New (Levered) Beta (at debt-to-equity ratio of 40%:60%)

( )( )
( )( )

New (Levered) Beta (at debt-to-equity ratio of 50%:50%)

( )( )
( )( )

In determining the Optimal Capital Structure, the following are the determinants:

1. Highest Stock Price

2. Lowest Weighted Average Cost of Capital
3. Not necessarily the highest EPS. The optimal debt ratio shall be the debt ratio next to the debt ratio
with the highest EPS.

In this problem, WACC shall be computed in order to determine the Optimal Capital Structure.

WACC = [Kd (1-TR) DR] +[ (Ke)ER]

(At 10: 90) WACC = [7% (1-0.4) 10%] +[ (16.24%)90%] = 15.04%

(At 20: 80) WACC = [7.2% (1-0.4) 20%] +[ (17.04%)80%] = 14.50%

(At 30: 70) WACC = [8% (1-0.4) 30%] +[ (18.08%)70%] = 14.10%

(At 40: 60) WACC = [8.8% (1-0.4) 40%] +[ (19.44%)60%] = 13.78%

(At 50: 50) WACC = [9.6% (1-0.4) 50%] +[ (21.36%)50%] = 13.56%

1. What is the beta levered at 10:90 debt to equity ratio? 1.28
2. What is the unlevered beta using Hamada Equation? 1.20
3. What is the Beta coefficient for each level of debt ratio (20%;30%;40%;50%)? (refer to table)
4. What is the cost of equity for each level of equity ratio (80%;70%:60%;50%)? (refer to table)
5. What is the after tax cost of debt for each level of debt ratio (10%;20%;30%;40%;50%)
6. What is the Weighted Average Cost of Capital for each capital structure? (refer to table)
7. What is the weight of debt at optimal capital structure? 50%
8. What is the weight of equity at optimal capital structure? 50%

PROFITABILITY RATIOS:

ROA =

ROE =

( )
ROIC= =

IF the ROIC is higher than WACC, the value of the firm increases.
IF the firm is unlevered, ROA = ROE = ROIC