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To Jerry Bowman
Date: 29 May 2008
Subject: Optimal Capital Structure for Postie Plus Group Limited
The purpose of this report is to address the issue of PPG’s capital structure. Our analysis will firstly provide a point estimate for the optimal capital structure and then suggest a range within which the firm’s value will not deviate much from its optimal value. Our methodology for the analysis will start by determining the cost of debt, the cost of equity which therefore gives us the WACC for PPG. Next we will determine FCF so that we can calculate the value of the firm since the value of the value of the firm is the present value of FCF. Lastly, we will compare the optimal capital structure with its current capital structure and provide a recommendation.
Determining Cost of Debt
To calculate the cost of debt we first had to determine the risk free rate. Using the 10 year maturity government bond we obtained a rate of 6.7%. A debt premium of 2% was added to this to account for the risk inherent in the business. The debt premium is necessary because the firm faces risks even though it has no debt. For example Postie Plus is in the clothing industry so they will face the risk of their clothes becoming obsolete due to changes in customers’ taste and preferences and seasonality changes. Next we had to determine how the cost of debt changes as debt increases in the firm. To do this we used Moody’s bond ratings and bond spreads. We assumed that when there is less than 10% debt, the cost of debt remains at the risk free rate plus the debt premium and as the level of debt increases, the bond decreases and the cost of debt increases according ...