Integrative—Optimal capital structure Medallion Cooling Systems, Inc., has total assets of $10,000,000, EBIT of $2,000,000, and preferred dividends of $200,000 and is taxed at a rate of 40%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:
Capital structure No. of common
debt ratio Cost of debt, kd stock shares Required return, ks
0% 0% 200,000 12%
15 8 170,000 13
30 9 140,000 14
45 12 110,000 16
60 15 80,000 20
a. Calculate earnings per share for each level of indebtedness.
b. Use Equation 12.12 and the earnings per share calculated in part a to calculate a price per share for each level of indebtedness.
c. Choose the optimal capital structure. Justify your choice.