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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

OPTIMAL CAPITAL STRUCTURE Jackson Trucking Company is in the process of setting its target capital structure. The CFO believes that the optimal debt-to-capital ratio is somewhere between 20% and 50%, and her staff has compiled the following projections for EPS and the stock price at various debt levels:

Debt/Capital

Ratio

Projected

EPS

Projected Stock Price
20% $3.20 $35.00
30 3.45 36.50
40 3.75 36.25
50 3.50 35.50

Assuming that the firm uses only debt and common equity, what is Jackson’s optimal capital structure? At what debt-to-capital ratio is the company’s WACC minimized?

Summary Introduction

To identify: The optimal capital structure of Company J and debt-to-capital to minimize WACC of company.

Optimal Capital Structure:

Optimal capital structure refers to a satisfactory debt-to-equity ratio through which the cost of capital of a firm can be minimized.

Explanation

Compute the optimal capital structure.

Compute the cost of capital when capital ratio is 20%.

Given,

The projected EPS is $3.20.

The projected stock price is $35.

Formula to calculate the cost of capital,

Costofcapital=EPSStockprice

Where,

  • EPS is earning per share.

Substitute $3.20 for EPS and $35 for stock price.

Costofcapital=$3.20$35=0.09143

The cost of capital at 20% capital ratio is 0.09143.

Compute the cost of capital when capital ratio is 30%.

Given,

The projected EPS is $3.45.

The projected stock price is $36.50.

Formula to calculate the cost of capital,

Costofcapital=EPSStockprice

Where,

  • EPS is earning per share.

Substitute $3.45 for EPS and $36.50 for stock price.

Costofcapital=$3.45$36.50=0.0945

The cost of capital at 30% capital ratio is 0.0945.

Compute the cost of capital when capital ratio is 40%.

Given,

The projected EPS is $3.75.

The projected stock price is $36.25.

Formula to calculate the cost of capital,

Costofcapital=EPSStockprice

Where,

  • EPS is earning per share.

Substitute $3.75 for EPS and $36.25 for stock price.

Costofcapital=$3.75$36.25=0.103

The cost of capital at 40% capital ratio is 0.103.

Compute the cost of capital when capital ratio is 50%

Given,

The projected EPS is $3.50.

The projected stock price is $35.50.

Formula to calculate the cost of capital,

Costofcapital=EPSStockprice

Where,

  • EPS is earning per share.

Substitute $3.50 for EPS and $35.50 for stock price.

Costofcapital=$3

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