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##### FIN - Compare and Contrast Different Methods for Determining Optimal Capital Structure

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Question;Q1. Compare and;Contrast Different Methods for Determining Optimal Capital Structure;The;Best Circuit Company currently has no profitable growth opportunities or;debt. An in-house research group has just been assigned the job of;determining whether the firm should change its capital structure. Because;of the importance of the decision, management has also hired the investment;banking firm of Stanley Morgan & Company to conduct a parallel analysis of;the situation. Mr. Harris, the in-house analyst, who is well versed in;modern finance theory, has decided to carry out the analysis using the MM;framework. Ms. Broske, the Stanley Morgan consultant, who has a good;knowledge of capital market conditions and is confident of her ability to;predict the firm?s debt and equity costs at various levels of debt, has decided;to estimate the optimal capital structure as that structure which minimizes the;firm?s weighted average cost of capital. The following data are relevant;to both analyses;EBIT;=;\$4 million per year;in perpetuity.;Federal-plus-state tax rate;=;40%.;Dividend payout ratio;=;100%.;Current required rate of return on equity;=;12%.;The cost of capital;schedule predicted by Ms. Broske follows;At a Debt Level of (Millions of Dollars);\$0;\$2;\$4;\$6;\$8;\$10;\$12;\$14;Interest rate (%);-;8.0;8.3;9.0;10.0;11.0;13.0;16.0;Cost of equity (%);12.0;12.5;13.25;13.75;14.5;15.75;17.25;19.0;Mr. Harris;estimated the present value of financial distress costs at \$20 million.;Additionally, he estimated the following probabilities of financial distress.;At a Debt Level of (Millions of Dollars);\$0;\$2;\$4;\$6;\$8;\$10;\$12;\$14;Probability of;financial distress (Note: doesn't add to 1.00);0;0;0.05;0.07;0.10;0.17;0.47;0.90;a. What level of debt would Mr. Harris and Ms.;Broske each recommend as optimal?;b. Explain the similarities and differences in their approaches;? not in their solutions. Is one approach right and the other therefore;wrong? Explain carefully!

Paper#49573 | Written in 18-Jul-2015

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