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 7% and market risk premium 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 company’s current cost of equity

ii) Calculate company’s unlevered beta
iii) Calculate new beta at 50% debt level
iv) Determine the company’s 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) Ajanta Ltd is examining its capital structure with the intent of arriving optimal debt ratio. It currently has
no debt and has beta of 1.5. The riskless interest rate is 9%. And market risk premium of 5.5%. Your research
indicates the debt rating at different debt level (Tax rate 40%)

Intrest
d/(d+e) Rating Rate

0% AAA 10%
10% AA 10.50%
20% A 11%
30% BBB 12%
40% BB 13%
50% B 14%
60% CCC 16%
70% CC 18%
80% C 20%
90% D 25%

The Firm Currently has 1 Million shares outstanding at Rs 20 per share

a) Determine firm’s optimal debt ratio?