Assume that you have just been hired by Adams, Garitty, and Evans (AGE), a consulting firm that specializes in analyses of firms’ capital structures. Your boss has asked you to examine the capital structure of Campus Deli and Sub Shop (CDSS), which is located adjacent to the campus. According to the owner, sales were $1,350,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. As a result, EBIT totaled $500,000. Because the university’s enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CDSS pays out all earnings as dividends. The management group owns 50% of the stock, which is traded in the over-the-counter market.
CDSS currently has no debt—it is an all equity firm—and its 100,000 shares outstanding sell at a price of $20 per share. The firm’s marginal tax rate is 40%. On the basis of statements made in your finance class, you believe that CDSS’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 to provide support for the suggestion.
You then obtained from a local investment banker the following estimates of the costs of debt and equity at different debt levels (in thousands of dollars):
Amount Borrowed rd rs
$ 0 —- 15.0%
200 10.0% 15.5
400 11.0 16.5
600 13.0 18.0
800 16.0 20.0
If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. You plan to complete your report by asking and then answering the following questions:
Consider the optimal capital structure for CDSS.
(1) To begin, define the term optimal capital structure.
(2) What is the WACC at debt levels of $0, $200,000, $400,000, $600,000 and $800,000?
(3) What is the optimal capital structure based on your calculation in (2)?