10/26/2022

APPROACHES TO OPTIMAL CAPITAL

Workshop
STRUCTURE
1

Understand the Objective of the case

RULES OF Do not begin in solving any part before

THINK-PAIR AND introduction

SHARE Think with your friend and cooperate in

WORKSHOP solving each part

Discuss with your friend and cooperate

in write comment on each part

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OPTIMAL CAPITAL STRUCTURE – CASE STUDY

A firm is contemplating changing the capital structure
of the firm.
Basic Data
All-Equity Capital Structure
The firm has EGP45,000,000 in total assets,

a. Complete the following table showing: 1. Debt = Debt ratio*total Assets

1. the values of debt,
2. equity, 2. Equity = Total Assets – Debt
3. the total number of shares of common
stock. 3. # of Shares outstanding = Equity/20
 The book value is $20 per share. 4. # of shares repurchased = debt/20

%debt Total Assets Debt ($) Equity ($) Number of Shares @20

0% 45,000,000

10%

20%

30%

40%

50%

60%

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WHAT YOU OBSERVE?

# of shares
%debt Total Assets Debt ($) Equity ($) Number of Shares @20
Repurchased
0% - 45,000,000
45,000,000 2,250,000 -
10% 4,500,000 40,500,000
45,000,000 2,025,000 225,000
20% 9,000,000 36,000,000
45,000,000 1,800,000 450,000
30% 13,500,000 31,500,000
45,000,000 1,575,000 675,000
40% 18,000,000 27,000,000
45,000,000 1,350,000 900,000
50% 22,500,000 22,500,000
45,000,000 1,125,000 1,125,000
60% 27,000,000 18,000,000
45,000,000 900,000 1,350,000

COMPLETE THE
FOLLOWING TABLE
INDICATING THE %DEBT
DEBT BEFORE-TAX COST INTEREST
TOTAL DEBT AND ($) OF DEBT, RD EXPENSE ($)
INTEREST EXPENSE FOR 0% 0.0%
EACH LEVEL OF
INDEBTEDNESS. 10% 7.0%

20% 8.0%
Get Debt from table
(1) 30% 9.5%

Interest expense = 40% 11.0%

debt amount* cost 50% 12.5%

of debt 60% 15.5%

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WHAT YOU OBSERVE?

%debt Debt ($)

Before-tax cost of debt, rd Interest Expense ($)
0% - 0.0% -
10% 4,500,000 7.0% 315,000
20% 9,000,000 8.0% 720,000
30% 13,500,000 9.5% 1,282,500
40% 18,000,000 11.0% 1,980,000
50% 22,500,000 12.5% 2,812,500
60% 27,000,000 15.5% 4,185,000

WHAT LEVEL OF
DEBT MAXIMIZE
EPS?
Profit
maximization
approach

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C. Using an EBIT of $7,500,000,

a 40% tax rate, and the
information developed in parts a
and b, Calculate the most likely
earnings per share (EPS) for the
firm at each level of
indebtedness.
EBT = EBIT – interest exp.
Taxes = EBT*Tax rate
Net Income = EBT – Taxes
You get # outstanding shares from
table (a)
EPS = Net Income/# of shares

WHAT YOU OBSERVE?

WHAT LEVEL OF DEBT USING PROFIT MAXIMIZATION
APPROACH?
%debt EBIT Interest Expense ($) EBT Taxes Net Income # of Shares outstanding EPS

0% 2
7,500,000 - 7,500,000 3,000,000 4,500,000 2,250,000
10% 2.129
7,500,000 315,000 7,185,000 2,874,000 4,311,000 2,025,000
20% 2.26
7,500,000 720,000 6,780,000 2,712,000 4,068,000 1,800,000
30% 2.369
7,500,000 1,282,500 6,217,500 2,487,000 3,730,500 1,575,000
40% 2.453
7,500,000 1,980,000 5,520,000 2,208,000 3,312,000 1,350,000
50% 2.5
7,500,000 2,812,500 4,687,500 1,875,000 2,812,500 1,125,000
60% 2.21
7,500,000 4,185,000 3,315,000 1,326,000 1,989,000 900,000

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WHAT LEVEL OF
DEBT MAXIMIZE
SHARE PRICE?
Wealth
maximization
approach

11

D. Complete the following table

showing the estimates of the value
per share at various levels of Share Price
indebtedness. The estimates of %debt EPS Rs ($)
required return are denoted by rs. 0% 10.0%
10% 10.3%
20% 10.9%
Using Gorden Model
30% 11.4%
P=DIV1/(r-g) 40% 12.6%
Assume that 50% 14.8%
60% 17.5%
Payout policy is 100%
There is no expected
growth
So, P = EPS/r
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%debt EPS rs Share Price ($)

0% 2.00 10.0% 20.00
10% 2.13 10.3% 20.67
20% 2.26 10.9% 20.73 WHAT YOU
30% 2.37 11.4% 20.78 OBSERVE?
40% 2.45 12.6% 19.47
50% 2.50 14.8% 16.89
60% 2.21 17.5% 12.63

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WHICH DEBT RATIO WOULD YOU

RECOMMEND? EXPLAIN YOUR ANSWER.
Share Price ($)
EPS Wealth Maximization
%debt Profit maximization approach Approach
0% 2.00 20.00
10% 2.13 20.67
20% 2.26 20.73
30% 2.37 20.78
40% 2.45 19.47
50% 2.50 16.89
60% 2.21 12.63

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PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION

25.00
EPS
20.78
20.67 20.73
20.00
19.47
3.00 20.00
2.50 16.89
2.45
2.50 2.37
2.26 2.21
2.13 15.00
2.00 12.63
2.00

10.00
1.50
Figure clearly shows that although the firm’s profits (EPS) are maximized at a
debt ratio of 50%, share value is maximized at a 30% debt ratio.
1.00 5.00
Therefore, the preferred capital structure would be the 30% debt ratio. The two
approaches provide different conclusions because EPS maximization does not
0.50
consider risk. 0.00
0% 10% 20% 30% 40% 50% 60%
0.00
Share Price ($)
0% 10% 20% 30% 40% 50% 60%

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