Given the following choices what is the optimal capital stru

Given the following choices, what is the optimal capital structure for Chip Co.? (Assume that the company\'s growth rate is 2%.)

Dividends

Cost of   

Debt Ratio   

Per Share

Equity (r _s)   

0%

$5.50

11.5%

25   

6.00

12.0   

40   

6.50

13.0   

50   

7.00

14.0   

75   

7.50

15.0   

0% debt; 100% equity

25% debt; 75% equity

40% debt; 60% equity

50% debt; 50% equity

75% debt; 25% equity

Solution

Optimal capital structure is where the share price is maximum.
Cost of Equity Dividend/( Cost of Equity - Growth)
1. For 0% debt Ratio Price of share = 5.5/(11.5% - 2%) = 57.89
2. For 25% debt Ratio Price of share = 6/(12% - 2%) =60.00
3. For 40% debt Ratio Price of share = 6.5/(13% - 2%) = 59.09
4. For 50% debt Ratio Price of share = 7.0/(14% - 2%) = 58.33
5. For 75% debt Ratio Price of share = 7.5/(15% - 2%) = 57.69

25% debt; 75% equity gives optimal capital structure as price = 60.00

Best of Luck. God Bless