Answered: Review this situation: Universal…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter13: Capital Structure Concepts

Section: Chapter Questions

Problem 4P

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Question

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	rdrd	rsrs	WACC
30%	70%	7.00%	10.50%	8.61%
40%	60%	7.20%	10.80%	8.21%
50%	50%	7.70%	11.40%	8.01%
60%	40%	8.90%	12.20%	8.08%
70%	30%	10.30%	13.50%	8.38%

Which capital structure shown in the preceding table is Universal Exports Inc.’s optimal capital structure?

Debt ratio = 70%; equity ratio = 30%

Debt ratio = 50%; equity ratio = 50%

Debt ratio = 60%; equity ratio = 40%

Debt ratio = 40%; equity ratio = 60%

Debt ratio = 30%; equity ratio = 70%

Consider this case:

Globex Corp. is an all-equity firm, and it has a beta of 1. It is considering changing its capital structure to 70% equity and 30% debt. The firm’s cost of debt will be 10%, and it will face a tax rate of 40%.

What will Globex Corp.’s beta be if it decides to make this change in its capital structure?

Now consider the case of another company:

US 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 2.5%, and the risk premium on the market is 7%. US 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 US Robotics Inc.’s unlevered beta.

Use US Robotics Inc.’s unlevered beta to solve for the firm’s levered beta with the new capital structure.

Use US 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?

8.0%

10.1%

10.6%

9.0%

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