Question

Harry Trading Company must choose its optimal capital structure. Currently, the firm has a 20 percent debt ratio and the firm expects to generate a dividend next year of $5.64 per share. Dividends are expected to remain at this level indefinitely. Stockholders currently require a 12.3 percent return on their investment. Harry is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will increase its expected dividend to $5.92 per share. Again, dividends are expected to remain at this new level indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 13.6 percent. Based on this information, should Harry make the change?

Answer 1

They should not make the change because the price of the stocks will decrease.

Step-by-step explanation:

the current price of the stocks using the perpetuity formula = dividend / required rate of return

current price with current capital structure = $5.64 / 0.123 = $45.85

if the company changes its capital structure by increasing debt, the price of the stocks will be

$5.92 / 0.136 = $43.53

since the price of the stocks would actually decrease if the capital structure changes, the change should not be made. The stockholders' wealth is measured by the price of the stocks, and if the price of the stocks decreases, then the stockholders' wealth also decreases.