Optimal Capital Structure for Chip Co.

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Given the following choices, what is the optimal capital structure for Chip Co.? (Assume that the company's growth rate is 2 percent.)

Debt Ratio -

Dividends -

Per Share ($)

Cost of Equity -

0%5.5011.5%

256.0012.0

406.5013.0

507.0014.0

757.5015.0

A. 50% debt; 50% equity

B. 40% debt; 60% equity

C. 25% debt; 75% equity

D. 75% debt; 25% equity

E. 0% debt; 100% equity

Click on the arrows to vote for the correct answer

A. B. C. D. E.

First, calculate the stock price for each debt level using the dividend growth model, Po = D1/(ks - g).

Debt Div/share ksPo -

0%$5.5011.5% $5.50/(0.115 - 0.02) = $57.89.

25%6.0012%$6.00/(0.12 - 0.02) = $60.00.

40%6.5013%$6.50/(0.13 - 0.02) = $59.09.

50%7.0014%$7.00/(0.14 - 0.02) = $58.33.

75%7.5015%$7.50/(0.15 - 0.02) = $57.69.

Clearly, $60.00 is the highest price, so 25% debt and 75% equity is the optimal capital structure.

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