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Optimum amount of debt

If a firm is financed solely by equity is considering issuing debt and using proceeds to repurchase some of the outstanding shares at the current market price of $34.61. There are currently 195,000 shares outstanding. EBIT is expected to remain at $1.1 million, with all earnings paid out as dividends. The firm can issue debt at a rate of 8.5% and the firm's tax rate is 36%. The 3 alternative amounts of debt are being considered;

Alternative #1
Amount of debt $0
Required return on equity 13%

Amount of debt $500,000
Required Return on Equity 13.41%

Alternative #3
Amount of debt $1,000,000
Required Return on Equity 13.88%

What would be the optimum amount of debt?

Also at optimum capital structure, the firm minimizes the WACC and maximizes both the total firm value and the price of the outstanding shares?

Solution Preview

The optimum amount of debt is when the WACC is minimum.
We calculate the WACC at different levels of debt
WACC can be calculated using the equation
Value of firm = EBIT (1-Tax)/WACC
Alternative #1
Here debt is zero, so WACC will be the cost of equity = 13%
Value of firm (unlevered value) = 1,100,000 X (1-0.36)/13% = $5,415,384.62
Alternative #2
The value of firm will be the levered value since we have taken on debt
Value levered = Value ...

Solution Summary

The solution explains how to determine the optimum amount of debt