Question

QUL 4 (LU 5]
You are appointed as a financial consultant on optimal capital structure for a listed industrial firm. The firm's
Finance Manager is a fresh MBA from a reputed Business School and has repeatedly argued that a firm's
capital structure has no relevance and impact on its market value. However, the firm's CEO is not convinced
and fears the economy is heading into recession. He would like to make a final call after you have made your
recommendation. Your assistant has done some homework, which is presented below.
✓ The firm is presently highly leveraged. If EBIT increases / decreases by 10%, the firm can expect its EPS
to increase/decrease by 3 times i.e. by 30%.
Errea
The debt ratios of other firms in the same industry vary widely from 35% to 55%. On the one hand, there
are well established firms with stable client base. At the other extreme, there are late entrants in the market
with volatile client base. Yours is a mature fim with stable client base imparting steady cashflows.
Everyti
ent: W
✓ Cost of debt and cost of capital estimates for your firm at different levels of debt are given below.
thing
Debt
Ratio
0%
10%
20%
30%
40%
50%
60%
70%
80%
on tin
Debt
Rating
AAA
AAA
AA
AA
A
BBB
BB
CCC
с c
Cost of
Debt
10%
10.50%
11.00%
12.00%
13.50%
15,00%
17.00%
19.00%
23.00%
Cost of
Capital
19.00%
19.00%
18.00%
16.50%
15.50
15.50%
18.00%
23.00%
30.00%
oined
from
How could you possibly employ this information for decision making apart from other pieces of the puzzle
that you might have? Recommend a practical solution in the light of theory and practice of capital structure.
(20)​

Answer 1

Answer:

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