Rate of Return and Optimal Capital Structure. Central Furniture Company recently announced plans to expand its production capacity by building and equipping two new factories to operate in parallel with existing production facilities. The expansion will double the assets of the firm. The proposed expansion has received a lot of attention from industry observers due to the cyclical nature of the furniture industry and the size of the project. The new plants will require fewer workers than current plants of similar capacity because the new facilities will be highly automated.
Central Furniture must now decide how the plant expansion will be financed. The project will require $5 million in new funds and the expected return on the new assets is estimated at 12 percent before taxes, the same return that is currently earned on the existing assets. The two alternatives proposed to raise the needed funds are (1) private placement of long-term debt at an interest rate of 10 percent, and (2) issuance of new common stock at $25 per share.
Currently the company is financed equally by debt and equity as follows:
Long-term debt (8%) $2,500,000
Common stock ($1 par) $ 100,000
Paid-in capital on common stock $ 400,000
Retained earnings $2,000,000
Central Furniture’s common stock is currently traded on a stock exchange at a market price of $27 per share. Central Furniture is subject to a tax rate of 40 percent
(a) Compute Central Furniture Company’s anticipated rate of return on stockholders’ equity if the expansion project is financed by (1) private placement of long-term debt, and (2) issuance of common stock. (b) One of the two alternatives–long-term debt or common stock–will move Central Furniture Company to a more optimum capital structure. (1) What criteria are used to judge optimum capital structure? (2) Explain what factors influence the determination of an optimum capital structure. (CMA, adapted.)