Capital Structure
Assume that you have just been hired as business manager of Campus Deli(CD), located adjacent to the campus. Its Free Cash Flow(FCF) is $400,000. Because the university’s enrollment is capped, FCF is expected to be constant over time. Because no expansion capital is required, CD pays out all earnings as dividends. CD currently has no debt it is an all-equity firm and its 100,000 shares outstanding selling at $40 per share. The firm’s federal-plus-state tax rate is 35%.
On the basis of statements made in your finance text, you believe that CD’s shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea but supported the suggestion.
In today’s market, the risk-free rate is 5% and the market risk premium is 5%. CD’s unlevered beta is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 10%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars):
| Amount Borrowed | Debt/Asset Ratio | Bond Rating | Yield |
| $0 | 0 | — | — |
| 500 | 0.125 | AA | 8.0% |
| 1000 | 0.250 | A | 9.0% |
| 1500 | 0.375 | BBB | 11.0% |
| 2000 | 0.500 | BB | 13.0% |
Now answer the following questions:
- ) What is the optimal capital structure (or Debt/Asset ratio) in the above table?
- ) What is the firm value under the optimal capital structure?
- ) What is the stock price under the optimal capital structure?