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Mini Case: Capital Structure Decision
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Background Information
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Background Information:

Assume you are just appointed as a financial manager in a local public firm, BestTrucking. Your responsibility is to assist the CFO of the firm make value-enhancing financing decisions.

You notice that the company’s earnings before interest and tax (EBIT) was $50 million in the previous year and you expect it will remain at the same level forever. The firm is an all-equity firm now and its number of shares outstanding is 10 million shares.

Most firms’ shareholders would be financially better off if the firms start to borrow some debt and use financial leverage. When you suggested this to the CFO of the company, he encouraged you to provide in-depth analysis to convince other senior executives and the board of directors.

As a first step, assume that you obtained the following estimated costs of debt from the firm’s investment banker. Specifically, the following table shows the cost of debt at different capital structures for this BestTrucking company. It also shows the expected number of shares outstanding at different capital structure. If the company were to issue debt, it will use the fund to repurchase/retire part of the equity (i.e., so-called recapitalization). BestTrucking has 40% tax rate; its CAPM beta is 1.0. Assume the risk-free rate of return is 6% and the market risk premium is 6% too..
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Percent Financed
number of shares outstanding
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with debt, wdrdn
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0%0.0%
10 million shares
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20%8.0%
8 million shares
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30%8.5%
7 million shares
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40%10.0%
6 million shares
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50%12.0%
5 million shares
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 The CFO has been persuaded by the above theoretical analysis. The CFO agree that the firm should use some debt. Now, he asks a more specific question: “If we are going to use debt, how much debt should we borrow?” The CFO thus encourage you consider whether there is an optimal capital structure for BestTrucking that can maximize its firm value. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. (2) Then calculate the firm value (i.e., V). Based on the results, please make your suggestion on the “optimal capital structure” that can maximize firm value of BestTrucking company.
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