capital structure, the company is analyzing the effects of different levels of debt on its cost of capital and earnings per share. The company currently has no debt and is considering issuing $2,000,000 in debt at an interest rate of 8%.
To determine the optimal capital structure, the company needs to calculate the cost of debt, cost of equity, and weighted average cost of capital (WACC) at different levels of debt. The cost of debt can be calculated using the formula:
Cost of Debt = Interest Rate x (1 - Tax Rate)
Cost of Debt = 8% x (1 - 0.40) = 4.8%
Next, the cost of equity can be calculated using the Capital Asset Pricing Model (CAPM) formula:
Cost of Equity = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)
Assuming a risk-free rate of 3%, a beta of 1.2, and a market return of 10%, the cost of equity would be:
Cost of Equity = 3% + 1.2 x (10% - 3%) = 10.8%
The WACC can then be calculated using the formula:
WACC = (E/V) x Re + (D/V) x Rd x (1 - Tax Rate)
Where:
E = Market value of equity
V = Total value of the firm (E + D)
Re = Cost of equity
D = Market value of debt
Rd = Cost of debt
Assuming the market value of equity is $10,000,000 and the market value of debt is $2,000,000, the total value of the firm would be $12,000,000. Plugging in the values, the WACC would be:
WACC = ($10,000,000 / $12,000,000) x 10.8% + ($2,000,000 / $12,000,000) x 4.8% x (1 - 0.40) = 9.4%
By analyzing the WACC at different levels of debt, the company can determine the optimal capital structure that minimizes the cost of capital and maximizes earnings per share.