A firm is trying to determine its optimal capital structure, the company's CFO beliefs that the optimal debt ratio is between 20% to 50% .Her staff has compiled the following projection of company 's EPS and stock price for different debt levels
Debt ratio Eps Po
20% 3.2 35
30 3.45 36.5
40 3.75 36.25
50 3.5 35.5
What is optimal capital structure?
To determine the optimal capital structure, we need to find the debt ratio at which the company maximizes its stock price (Po) or earnings per share (EPS). Looking at the given information, we can observe the following projections:
Debt ratio: 20% | EPS: 3.2 | Po: 35
Debt ratio: 30% | EPS: 3.45 | Po: 36.5
Debt ratio: 40% | EPS: 3.75 | Po: 36.25
Debt ratio: 50% | EPS: 3.5 | Po: 35.5
To find the optimal capital structure, we need to identify the debt ratio at which the stock price or EPS is highest. From the given projections, we can see that the highest EPS is 3.75 at a debt ratio of 40%. However, the highest stock price is 36.5 at a debt ratio of 30%.
Based on this information, it is not clear which factor (EPS or stock price) to prioritize in determining the optimal capital structure. The CFO's belief that the optimal debt ratio is between 20% to 50% does not provide a more specific range. Further analysis or information is needed to determine the optimal capital structure.
To determine the optimal capital structure, we need to find the debt ratio that maximizes the firm's stock price or EPS.
One way to do this is by analyzing the relationship between the debt ratio and the stock price/EPS. Looking at the given data, we can see that both the EPS and stock price increase as the debt ratio increases from 20% to 30%. However, from 30% to 40%, while the EPS continues to increase, the stock price decreases slightly. At a debt ratio of 50%, both the EPS and stock price decrease compared to the previous level.
Based on this information, we can conclude that the optimal capital structure is likely to be somewhere between 30% and 40% debt ratio. This range represents the point at which the firm achieves a balance between maximizing EPS and stock price.
It's important to note that the optimal capital structure may vary based on other factors such as the market conditions, industry norms, and risk tolerance of the firm. Therefore, further analysis and consideration may be required to determine the precise optimal capital structure for the specific firm in question.