Module 05 Course Project - Presentation

Yomarie Miranda

Module 03 Course Project - Capital Structure

Optimal capital structure is the one that has lowest WACC. Lower the WACC, lower the discount rate and NPV would be higher.

There are several methods to find out WACC, namely; Net Income Approach, Net Operating Income Approach, Tradutional Approach. Each method has few assumptions.

· In Net income approach, cost of equity (Re) and cost of debt (Rd) are assumed to be constant.

· In Net Operating Income approach, cost of equity rises to compensate reduced cost of debt and keeps overall rate constant.

· In Traditional approach, cost of debt increases gradually due to which overall cost of capital falls initially. After certain point of leverage, debt suppliers would raise cost of debt and shareholders experience threat of debt interest and would expect higher returns raising cost of equity.

· Since cost of capital falls initially and then starts rising, there would be a point where overall capital cost would be minimum. This point would be Optimal capital structure.

I have used Traditional Appoach here:

Assumptions:

· EBIT of $300m each year and 4 scenarios have been considered with debt-equity ratio of (Scenario 1)1:9, (Scenario 2) 1:4, (Scenario 3) 1:1, (Scenario 4) 9:1.

· Tax rate hasn't been considered.

· Cost of debt and cost of equity have been assumed.

Formulae used:

1) Market value of debt = Interest / Cost of debt

2) Market value of equity = EAT / Cost of equity

3) Value of firm = Market value of debt + Market value of equity

4) WACC = EBIT / Value of firm

Outcomes of 4 scenarios are mentioned below in table:

	Scenario 1 D/E = 1:9	Scenario 2 D/E = 1:4	Scenario 3 D/E =1:1	Scenario 4 D/E = 9:1
Project Cost	50	50	50	50
Sources of Finance:
Equity	45	40	25	5
Debt	5	10	25	45
Capitalization Rate:
Debt (Rd)	10%	11%	12%	13%
Equity (Re)	20%	20%	25%	30%
EBIT	300	300	300	300
Interest (Debt*Rd)	0.5	1.1	3	5.85
EBT	299.5	298.9	297	294.15
Tax	No tax	No tax	No tax	No tax
EAT	299.5	298.9	297	294.15
Market Value of debt (Interest/Rd)	5	10	25	45
Market Value of equity (EAT/Re)	1497.5	1494.5	1188	980.5
Value of firm	1502.5	1504.5	1213	1025.5
WACC	0.1996	0.1994	0.2473	0.2925
Traditional Approach (in mil)

WACC (in %) for below scenarios:

Scenario 1: 19.96%

Scenario 2: 19.94%

Scenario 3: 24.73%

Scenario 4: 29.25%

Optimal Capital structure would be Scenario 2 i.e.; Debt/Equity = 1/4 since WACC is lowest.