Debt Ratio Equity Ratio rdrd rsrs WACC 30% 70% 6.02% 9.40% 9.71% 40% 60% 6.75% 9.750% 9.55% 50% 50% 7.15% 10.60% 10.02% 60% 40% 7.55% 11.30% 10.78% 70% 30% 8.24% 12.80% 11.45%
Debt Ratio Equity Ratio rdrd rsrs WACC 30% 70% 6.02% 9.40% 9.71% 40% 60% 6.75% 9.750% 9.55% 50% 50% 7.15% 10.60% 10.02% 60% 40% 7.55% 11.30% 10.78% 70% 30% 8.24% 12.80% 11.45%
Chapter13: Capital Structure Concepts
Section: Chapter Questions
Problem 5P
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Financial Ratios
A Ratio refers to a figure calculated as a reference to the relationship of two or more numbers and can be expressed as a fraction, proportion, percentage, or the number of times. When the number is determined by taking two accounting numbers derived from the financial statements, it is termed as the accounting ratio.
Return on Equity
The Return on Equity (RoE) is a measure of the profitability of a business concerning the funds by its stockholders/shareholders. ROE is a metric used generally to determine how well the company utilizes its funds provided by the equity shareholders.
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eview 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% | 6.02% | 9.40% | 9.71% |
40% | 60% | 6.75% | 9.750% | 9.55% |
50% | 50% | 7.15% | 10.60% | 10.02% |
60% | 40% | 7.55% | 11.30% | 10.78% |
70% | 30% | 8.24% | 12.80% | 11.45% |
Which capital structure shown in the preceding table is Universal Exports Inc.’s optimal capital structure?
Debt ratio = 70%; equity ratio = 30%
Debt ratio = 30%; equity ratio = 70%
Debt ratio = 50%; equity ratio = 50%
Debt ratio = 60%; equity ratio = 40%
Debt ratio = 40%; equity ratio = 60%
Consider this case:
Globex Corp. currently has a capital structure consisting of 35% debt and 65% equity. However, Globex Corp.’s CFO has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 3%, the market risk premium is 7.5%, and Globex Corp.’s beta is 1.25.
If the firm’s tax rate is 25%, what will be the beta of an all-equity firm if its operations were exactly the same?
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 6%, and its tax rate is 25%. It currently has a levered beta of 1.25. The risk-free rate is 3%, and the risk premium on the market is 7.5%. 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 8%.
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?
6.54%
8.72%
10.90%
11.99%
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