Question

Terrell Trucking Company is in the process of setting its target capital structure. The CFO believes that the optimal debt-to-capital ratio is somewhere between 20% and 50%, and her staff has compiled the following projections for EPS and the stock price at various debt levels:
Debt/Capital Ratio Projected EPS Projected Stock Price
20% $3.15 $35.00
30 3.60 35.75
40 3.70 37.00
50 3.55 32.25

Required:
a. Assuming that the firm uses only debt and common equity, what is Terrell's optimal capital structure?
b. At what debt-to-capital ratio is the company's WACC minimized?

Answer 1

Answer:

a. Terrell's Optimal Capital Structure is 40:60. It means to obtain optimal capital structure in-order to increase value of firm, Terrell should finance 40% of its Assets through Debt and remaining through Common Equity.

b. The optimal Capital Structure is the point where company's WACC is minimized. So, 40:60 is the ratio where Terrell's WACC will be minimized.

Explanation:

The goal of Management is to increase Shareholders' wealth and not to generate profits because wealth is something that is for long-run whereas Profits are temporary. Management would accept projects having negative NPV if its goal is to maximize Profit.

Maximizing Shareholders' wealth means to increase the Share Price whereas Generating a higher EPS is Profit Maximization Strategy. So, you should look for that Capital Structure Point where the Company's Stock Price is Highest.

Thanks!