Question

Integrative—Optimal capital structure Medallion Cooling Systems, has total assets of $10,500,000, EBIT of $2,010,000, and preferred dividends of $199,000 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% 7.9 Number of common stock shares 203,000 169,000 143,000 107,000 80,000 Required return, rs 12.2% 13.1 13.7 8.9 11.8 15.9 14.7 20.2

Answer 1

Debt Ratio	Debt	rd	Net Income	Shares	EPS	rs	P0	Firm Value
0%	-	0%	1,007,000	203,000	$      4.96	12.20%	$   40.66	$ 8,254,098
15%	1,575,000	7.90%	932,345	169,000	$      5.52	13.10%	$   42.11	$ 8,692,137
30%	3,150,000	8.90%	838,790	143,000	$      5.87	13.70%	$   42.82	$ 9,272,555
45%	4,725,000	11.80%	672,470	107,000	$      6.28	15.90%	$   39.53	$ 8,954,371
60%	6,300,000	14.70%	451,340	80,000	$      5.64	20.20%	$   27.93	$ 8,534,356

Debt = Debt Ratio x Total Assets

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

EPS = Net Income / Shares

Price P0 = EPS / rs

Firm Value = P0 x Shares + Debt

Optimal Capital Structure is the one where the firm value is the highest, which is when debt ratio = 30%