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% $3.00 $34.75 30 3.65 36.50 40 3.80 37.75 50 3.55 32.25 Assuming that the firm uses only debt and common equity, what is Terrell's optimal capital structure? Round your answers to two decimal places. % debt % equity At what debt-to-capital ratio is the company's WACC minimized? Round your answer to two decimal places. %

Answer 1

Answer:

40% or 0.4

Step-by-step explanation:

The optimal capital structure (OCS) of a firm is defined as "the proportion of debt and equity that results in the lowest weighted average cost of capital (WACC) for the firm"

The brief explanation of this is that OCS is the factor used by a company in maximising their stock price, and this generally calls for a Debt-to-capital or "Debit-to-equity" ratio.

From the table above, the company's stock ratio is highest or maximised at 37.75 (under Projected Stock Price Column)

This can be traced to 40% under Debt/Capital ratio column

Hence, the Debt/Capital Ratio of 40%,

Because it must equate to 100%, we say that the firm's optimal capital structure is 40% debt and 60% equity.

This is also the debt to capital ratio, where the firms WACC is minimized.