Optimal Capital Structure

Q.1) ABC Ltd current capital structure comprises of 20% debt and 80% equity capital and the current beta
on its share is 1.25. The risk free rate is 6% and tax rate applicable is 30%. The company is considering
changing its capital structure to finance 50% with debt and 50% with equity

i) Calculate companys current cost of equity

ii) Calculate companys unlevered beta
iii) Calculate new beta at 50% debt level
iv) Determine the companys new cost of equity

Q.2) The following are the betas of the equity of four paper product companies and their debt equity
ratios. All the firm faces tax rate 40%

Company Beta D/E

Weyer 1.15 33.91%
Champion 1.18 54.14%
International paper 1.05 45.50%
Kimberly 0.91 11.29%

a) Estimate the unlevered beta of each firm

b) Assume now that Kimberly is planning to increase its debt/equity ratio to 30% What will be its
new beta

Q.3) In considering the most appropriate capital structure for the NOID Manufactures Ltd (NML) its
finance department has made estimates of the interest rate on debt and the cost of equity capital at various
level of Debt/Equity mix summarized below

Coup
on
D/ Rate Ke(
E (%) %)
0 8 12
10 8 12
20 9 12.5
30 9 13.5
40 10 14.5
50 13 16
60 15 20
70 18 25
The debt is in the form of 10 year redeemable at par Rs 1000 debentures with coupen rates varying with
equity-debt ratio and 5% floatation cost. As a matter of policy, NML always keeps 10% of the finances in
form of preference shares carrying 2% extra return compared to the debenture coupon rate. The duration
and the floatation costs are similar to debentures. In D/E , equity includes 10% of preference shares

Corporate Tax @35%