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AC1978
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Help With M&M Question - April 11th, 2009

Currently working on financial leverage and capital structure policy and came across this question that has me stumped. At this point I think I'm starting to over think/analyze my questions. Any help would be appreciated. Thanks in advance.

A firm financed solely by equity is considering issuing debt and using the proceeds to repurchase some of the outstanding shares at the current market price of $34.61. There are currently 195,000 shares outstanding. EBIT is expected to remain at $1.1 million, with all earnings paid out as dividends. The firm can issue debt at a rate of 8.5 percent, and the firmís tax rate is 36 percent. Three alternative amounts of debt are being considered:
Amount of debt 0 $500,000 $1,000,000
Required return on equity 13% 13.41% 13.88%

a) What is the optimum amount of debt?
b) Show that, at the optimum capital structure, the firm minimizes the WACC and maximizes both the total firm value and the price of outstanding shares.
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Rose Marry
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Re: Help With M&M Question - April 9th, 2016

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Originally Posted by AC1978 View Post
Currently working on financial leverage and capital structure policy and came across this question that has me stumped. At this point I think I'm starting to over think/analyze my questions. Any help would be appreciated. Thanks in advance.

A firm financed solely by equity is considering issuing debt and using the proceeds to repurchase some of the outstanding shares at the current market price of $34.61. There are currently 195,000 shares outstanding. EBIT is expected to remain at $1.1 million, with all earnings paid out as dividends. The firm can issue debt at a rate of 8.5 percent, and the firmís tax rate is 36 percent. Three alternative amounts of debt are being considered:
Amount of debt 0 $500,000 $1,000,000
Required return on equity 13% 13.41% 13.88%

a) What is the optimum amount of debt?
b) Show that, at the optimum capital structure, the firm minimizes the WACC and maximizes both the total firm value and the price of outstanding shares.
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