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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

OPTIMAL CAPITAL STRUCTURE Terrell 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% $3.10 $34.25
30 3.55 36.00
40 3.70 35.50
50 3.55 34.00

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

Summary Introduction

To determine: The Company’s optimal capital structure and the debt to capital ratio at which the weighted average cost of capital is minimized.

Introduction:

Optimal Capital Structure:

The capital structure that optimizes three types of capital, which are debt, equity capital and preferred share in such a way that the total cost of the capital is minimized is the optimal capital structure. This structure maximizes the stock price of the firm and makes the debt to the capital ratio lower than the expected earnings per share.

Explanation

Given information:

The CFO has a belief that the optimal debt to capital ratio is between 20% and 50%.

The projected stock price is highest in debt to capital ratio of 30%.

As the primary aim of the optimal capital structure is to maximize the stock price of the company, the optimal capital structure is in debt to capital ratio of 30%. At the highest debt to capital ratio, the weighted average cost of capital is minimized.

  • The capital structure is the structure with the help of which the company finances all working operations...

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