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24 April, 18:16

Feldspar Inc. is considering the capital structure for a new division. Management has been given the following cost information:

Debt/assets

.30,.40,.50,.60,.70

Kd

.10,.105,.11,.117,.13

Ke

.125,.13,.135,.142,.155

Based on this information, what capital structure (debt/asset ratio) should management accept? Assume the marginal tax rate is 40%

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Answers (1)
  1. 24 April, 21:31
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    Option 4

    Explanation:

    In this question, we have to compute the WACC which is shown below:

    = Weightage of debt * cost of debt * (1 - tax rate) + (Weightage of common stock) * (cost of common stock)

    For Option 1, it would be

    = (0.3 * 10%) * (1 - 40%) + (0.7 * 12.5%)

    = 1.8% + 8.75%

    = 10.55%

    For Option 2, it would be

    = (0.4 * 10.5%) * (1 - 40%) + (0.6 * 13%)

    = 2.52% + 7.8%

    = 10.32%

    For Option 3, it would be

    = (0.5 * 11%) * (1 - 40%) + (0.5 * 13.5%)

    = 3.3% + 6.75%

    = 10.05%

    For Option 4, it would be

    = (0.6 * 11.7%) * (1 - 40%) + (0.4 * 14.2%)

    = 4.212% + 5.68%

    = 9.89%

    For Option 5, it would be

    = (0.7 * 13%) * (1 - 40%) + (0.3 * 15.5%)

    = 5.46% + 4.65%

    = 10.11%

    So based on this, the management should accept option 4 as it derives the best debt asset ratio

    The weightage of equity would be come

    = 1 - weightage of debt
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