Nico 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 $5.44 per share. Dividends are expected to remain at this level indefinitely. Stockholders currently require a 12.1 percent return on their investment. Nico 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 $5.82 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 12.6 percent. Based on this information, should Nico make the change?
A) Yes.
B) No.
C) It's irrelevant.
D) Not enough information.

Question

Quizplus · Accepted Answer

By increasing the debt ratio to 30 percent, Nico Trading Company will be able to increase its expected dividend to $5.82 per share. Since dividends are expected to remain at this new level indefinitely, shareholders will receive higher returns. The increase in dividend will compensate for the increased risk due to the added debt. The required return demanded by stockholders will increase to 12.6 percent, which is still below the expected return generated by the new dividend rate. Therefore, Nico Trading Company should make the change, and the optimal capital structure for the firm would be 30 percent debt ratio.

Nico Trading Company Must Choose Its Optimal Capital Structure