Circular Tire Works Capital Structure

Circular Tire Works Capital Structure
Name:
Institution:
Capital Structure for Circular Tire Works
Circular Tire Works is a small publically traded chain of tire shops. Circular is quite proud of the fact that it has no debt in its capital structure. However, they have just hired a newly minted VCU finance major, Bo Loated, who has questioned the no debt policy. Bo has indicated that Circular can increase the value of the company, and the share price, by issuing debt, and buying back shares of stock with the proceeds from the debt. Circular’s CFO, Ms. Ima Notshure feels there may be some merit to Bo’s argument (since Bo knows), but felt at some point the additional risk and costs of financial distress would outweigh the benefits. Ima believes that when that point is reached, the WACC would stop declining and start increasing, and the value per share of common stock, would stop rising, and in fact decrease. Ima asked her bankers to give her the cost of debt at various degrees of financial leverage. She then turned to Bo and charged him with determining the approximate level of debt at which the costs of additional debt outweigh the benefits. Bo not being prepared to actually perform the analysis himself has turned to a financial analyst to help him solve that problem.
This paper seeks to estimate how a given change in the capital structure will affect the stock price. In doing this analysis, it is important to note that the capital structure that maximizes the stock price is also the one that minimizes the WACC. The predicted changes in the WACC will be used to guide the capital structure decisions that should be taken by Circular Tire Works.
In this case, with no preferred stock provided, the Weighted Average Cost of Capital (WACC) will be determined as follows.
WACC = wd (kd) (1 T) wc (ks)
= (D/A) (kd) (1 T) (E/A) (ks).
Where D/A and E/A represent the debt and equity ratios, and they sum to 1.0.
Based on the provided entries,
Ordinary share capital 50,000,000...