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ABC Manufacturing Ltd., a mid-sized company, is planning to expand its operations by setting up a new production facility. The financial planning team estimates the project cost at $10 million. The company's finance manager must decide how to fund this project and evaluate its profitability.

The finance team forecasts future cash flows, determining that $6 million can be sourced internally through retained earnings. They prepare a financial budget aligning expected inflows and outflows with the company's goals.

The finance manager evaluates options for the remaining $4 million, including issuing equity or taking a bank loan. After analyzing interest rates and dilution of ownership, they decided to issue long-term debt at a 5% interest rate.

A detailed capital budgeting process is conducted. Using Net Present Value (NPV) and Internal Rate of Return (IRR), the project shows an NPV of $2 million and an IRR of 18%, higher than the company's hurdle rate of 12%. The investment is approved.

Post-debt issuance, the company's capital structure becomes 60% equity and 40% debt, maintaining an optimal balance to minimize the cost of capital.

The company plans to allocate funds for raw materials, labor, and inventory to ensure smooth operations. Efficient working capital management will reduce bottlenecks during the initial phases of production.

What is an optimal capital structure for ABC Ltd.?

Solution

✅ Correct Option: 3

Option 1 -> 100% equity financing increases the weighted average cost of capital (WACC) as equity is more expensive than debt, making it suboptimal.

Option 2 -> 100% debt financing maximizes financial risk, increases probability of bankruptcy, and makes the capital structure unsustainable and extremely risky.

Option 3 -> An optimal mix of debt and equity balances the tax benefits of debt with financial risk, minimizing WACC and maximizing firm value.

Option 4 -> A fixed 50-50 ratio is arbitrary and ignores company-specific factors like industry, growth stage, and risk tolerance that determine optimal structure.


Hence, Option 3: A mix of debt and equity to minimize cost of capital -> The optimal capital structure theory suggests that firms should balance debt and equity to achieve the lowest weighted average cost of capital (WACC). This approach leverages the tax shield benefits of debt while avoiding excessive financial risk, ultimately maximizing shareholder value. The exact proportion varies by company based on factors like industry norms, business risk, and growth prospects. -> correct

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