Financial management course

1. 10/26/2022
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APPROACHES TO OPTIMAL CAPITAL
STRUCTURE Workshop
RULES OF
THINK-PAIR AND
SHARE
WORKSHOP
Understand the Objective of the case
Do not begin in solving any part before
introduction
Think with your friend and cooperate in
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,
1. Debt = Debt ratio*total Assets
2. Equity = Total Assets – Debt
3. # of Shares outstanding = Equity/20
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%
a. Complete the following table showing:
1. the values of debt,
2. equity,
3. the total number of shares of common
stock.
 The book value is $20 per share.
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WHAT YOU OBSERVE?
%debt Total Assets Debt ($) Equity ($) Number of Shares @20
# of shares
Repurchased
0%
45,000,000
- 45,000,000
2,250,000 -
10%
45,000,000
4,500,000 40,500,000
2,025,000 225,000
20%
45,000,000
9,000,000 36,000,000
1,800,000 450,000
30%
45,000,000
13,500,000 31,500,000
1,575,000 675,000
40%
45,000,000
18,000,000 27,000,000
1,350,000 900,000
50%
45,000,000
22,500,000 22,500,000
1,125,000 1,125,000
60%
45,000,000
27,000,000 18,000,000
900,000 1,350,000
COMPLETE THE
FOLLOWING TABLE
INDICATING THE
TOTAL DEBT AND
INTEREST EXPENSE FOR
EACH LEVEL OF
INDEBTEDNESS.
Get Debt from table
(1)
Interest expense =
debt amount* cost
of debt
%DEBT
DEBT
($)
BEFORE-TAX COST
OF DEBT, RD
INTEREST
EXPENSE ($)
0% 0.0%
10% 7.0%
20% 8.0%
30% 9.5%
40% 11.0%
50% 12.5%
60% 15.5%
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WHAT YOU OBSERVE?
%debt Debt ($)
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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EBT = EBIT – interest exp.
Taxes = EBT*Tax rate
Net Income = EBT – Taxes
You get # outstanding shares from
table (a)
EPS = Net Income/# of shares
C. Using an EBIT of $7,500,000,
a 40% tax rate, and the
information developed in parts a
and b, Calculate the most likely
earnings per share (EPS) for the
firm at each level of
indebtedness.
WHAT YOU OBSERVE?
WHAT LEVEL OF DEBT USING PROFIT MAXIMIZATION
APPROACH?
%debt EBIT Interest Expense ($) EBT Taxes Net Income # of Shares outstanding EPS
0%
7,500,000 - 7,500,000 3,000,000 4,500,000 2,250,000
2
10%
7,500,000 315,000 7,185,000 2,874,000 4,311,000 2,025,000
2.129
20%
7,500,000 720,000 6,780,000 2,712,000 4,068,000 1,800,000
2.26
30%
7,500,000 1,282,500 6,217,500 2,487,000 3,730,500 1,575,000
2.369
40%
7,500,000 1,980,000 5,520,000 2,208,000 3,312,000 1,350,000
2.453
50%
7,500,000 2,812,500 4,687,500 1,875,000 2,812,500 1,125,000
2.5
60%
7,500,000 4,185,000 3,315,000 1,326,000 1,989,000 900,000
2.21
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WHAT LEVEL OF
DEBT MAXIMIZE
SHARE PRICE?
Wealth
maximization
approach
Using Gorden Model
P=DIV1/(r-g)
Assume that
Payout policy is 100%
There is no expected
growth
So, P = EPS/r
%debt EPS Rs
Share Price
($)
0% 10.0%
10% 10.3%
20% 10.9%
30% 11.4%
40% 12.6%
50% 14.8%
60% 17.5%
D. Complete the following table
showing the estimates of the value
per share at various levels of
indebtedness. The estimates of
required return are denoted by rs.
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WHAT YOU
OBSERVE?
%debt EPS rs Share Price ($)
0% 2.00 10.0% 20.00
10% 2.13 10.3% 20.67
20% 2.26 10.9% 20.73
30% 2.37 11.4% 20.78
40% 2.45 12.6% 19.47
50% 2.50 14.8% 16.89
60% 2.21 17.5% 12.63
WHICH DEBT RATIO WOULD YOU
RECOMMEND? EXPLAIN YOUR ANSWER.
%debt
EPS
Profit maximization approach
Share Price ($)
Wealth Maximization
Approach
0% 2.00 20.00
10% 2.13 20.67
20% 2.26 20.73
30% 2.37 20.78
40% 2.45 19.47
50% 2.50 16.89
60% 2.21 12.63
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PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION
20.00
20.67 20.73
20.78
19.47
16.89
12.63
0.00
5.00
10.00
15.00
20.00
25.00
0% 10% 20% 30% 40% 50% 60%
Share Price ($)
2.00
2.13
2.26
2.37
2.45
2.50
2.21
0.00
0.50
1.00
1.50
2.00
2.50
3.00
0% 10% 20% 30% 40% 50% 60%
EPS
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.
Therefore, the preferred capital structure would be the 30% debt ratio. The two
approaches provide different conclusions because EPS maximization does not
consider risk.
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