Principles of Managerial Finance

552 PART 4 Long-Term Financial Decisions

LG3 LG4 LG6^12 – 22 Integrative—Optimal capital structure Nelson Corporation has made the fol-

lowing forecast of sales, with the associated probabilities of occurrence noted.

The company has fixed operating costs of $100,000 per year, and variable oper-

ating costs represent 40% of sales. The existing capital structure consists of

25,000 shares of common stock that have a $10 per share book value. No other

capital items are outstanding. The marketplace has assigned the following

required returns to risky earnings per share.

The company is contemplating shifting its capital structureby substituting debt

in the capital structure for common stock. The three different debt ratios under

consideration are shown in the following table, along with an estimate, for each

ratio, of the corresponding required interest rate on alldebt.

The tax rate is 40%. The market value of the equity for a leveraged firm can be

found by using the simplified method (see Equation 12.12).

a. Calculate the expected earnings per share (EPS), the standard deviation of

EPS, and the coefficient of variation of EPS for the three proposed capital

structures.

b. Determine the optimal capital structure, assuming (1) maximization of earn-

ings per share and (2) maximization of share value.

c. Construct a graph (similar to Figure 12.7) showing the relationships in

partb.(Note:You will probably have to sketch the lines, because you have

only three data points.)

Debt Interest rate

ratio on all debt

20% 10%

40 12

60 14

Coefficient of Estimated required

variation of EPS return, ks

0.43 15%

0.47 16

0.51 17

0.56 18

0.60 22

0.64 24

Sales Probability

$200,000 .20

300,000 .60

400,000 .20