# Optimal Capital Structure

The market value of the equity for a levered firm can be found by using the simplified method.

a) Calculate the expected earnings per share (EPS), the standard deviation of EPS, and the coefficient of variation of EPS for the three proposed capital structures.

b) Determine the optimal capital structure, assuming (1) maximisation of earnings per share and (2) maximisation of share value.

c) Construct a graph showing the relationships in b

I am preparing myself for the coming exams on 10th of June 2006

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#### Solution Preview

Structure Debt Equity Interest Rate

A - 250,000 This is the existing structure with no debt

B 50,000 200,000 10% The equity is reduced by the amount of debt taken

C 100,000 150,000 12%

D 150,000 100,000 14%

EPS Calculation

Structure A

Probability 0.2 0.6 0.2

Sales 200,000 300,000 400,000

Less: Variable Cost (40%) 80,000 120,000 160,000

Less: Fixed Costs 100,000 100,000 100,000

EBIT 20,000 80,000 140,000

Less: Interest - - - There is no debt

Earnings Before Taxes 20,000 80,000 140,000

Tax (40%) 8,000 32,000 56,000

Net Income 12,000 48,000 84,000

No. of Shares 25,000 25,000 25,000 ...

#### Solution Summary

The solution explains how to determine the optimal capital structure.