Q1.  Compare and Contrast Different Methods for Determining Optimal Capital Structure

The Best Circuit Company currently has no profitable growth opportunities or debt.  An in-house research group has just been assigned the job of determining whether the firm should change its capital structure.  Because of the importance of the decision, management has also hired the investment banking firm of Stanley Morgan & Company to conduct a parallel analysis of the situation.  Mr. Harris, the in-house analyst, who is well versed in modern finance theory, has decided to carry out the analysis using the MM framework.  Ms. Broske, the Stanley Morgan consultant, who has a good knowledge of capital market conditions and is confident of her ability to predict the firm’s debt and equity costs at various levels of debt, has decided to estimate the optimal capital structure as that structure which minimizes the firm’s weighted average cost of capital.  The following data are relevant to both analyses:

 EBIT = \$4 million per year, in perpetuity. Federal-plus-state tax rate = 40%. Dividend payout ratio = 100%. Current required rate of return on equity = 12%.

The cost of capital schedule predicted by Ms. Broske follows

 At a Debt Level of (Millions of Dollars) \$0 \$2 \$4 \$6 \$8 \$10 \$12 \$14 Interest rate (%) – 8.0 8.3 9.0 10.0 11.0 13.0 16.0 Cost of equity (%) 12.0 12.5 13.25 13.75 14.5 15.75 17.25 19.0

Mr. Harris estimated the present value of financial distress costs at \$20 million.  Additionally, he estimated the following probabilities of financial distress.

 At a Debt Level of (Millions of Dollars) \$0 \$2 \$4 \$6 \$8 \$10 \$12 \$14 Probability of financial distress (Note: doesn’t add to 1.00) 0 0 0.05 0.07 0.10 0.17 0.47 0.90

a.       What level of debt would Mr. Harris and Ms. Broske each recommend as optimal?

b.      Explain the similarities and differences in their approaches – not in their solutions.  Is one approach right and the other therefore wrong?  Explain carefully!