Question

Integrative-Optimal capital structure Medallion Cooling Systems, has total assets of $9,400,000, EBIT of $1,960,000, and preferred dividends of $196,000 and is taxed at a rate of 40%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment: Capital structure debt ratio 0% Cost of debt, rd 0% 15 7.9 Number of common stock shares 203,000 171,000 136,000 111,000 80,000 Required return, rs 12.2% 13.3 14.2 15.9 19.9 8.7 11.8 15.3

Answer 1

Debt Ratio	Debt	rd	Shares	rs	Net Income	EPS	Price
0%	0	0%	203,000	12.20%	980,000	4.83	39.57
15%	1,410,000	7.90%	171,000	13.30%	913,166	5.34	40.15
30%	2,820,000	8.70%	136,000	14.20%	832,796	6.12	43.12
45%	4,230,000	11.80%	111,000	15.90%	680,516	6.13	38.56
60%	5,640,000	15.30%	80,000	19.90%	462,248	5.78	29.04

Debt = Debt Ratio x Asset Value

Net Income = (EBIT - Debt x rd) x (1 - tax rate) - Preferred Dividends

EPS = Net Income / Shares

Price = EPS / rs

Optimal capital structure is one where the price and firm value is maximized and hence, at 30% debt level.