5-12 Elliot Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity.
5-12 WACC and Optimal Capital Structure
Intermediate Financial Management By Eugene F. Brigham, Philip R. Daves 10th Ed
5-12 Elliot Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much debt would cost at different debt levels, the company’s treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:
Market Debt-To-Value Ratio (Wd) | Market Equity-To-Value Ratio (We) | Market Debt-To-Equity Ratio (D/S) | Bond Rating | Before-Tax Cost of Debt (rd) |
0.0 | 1.0 | 0.00 | A | 7.0% |
0.2 | 0.8 | 0.25 | BBB | 8.0% |
0.4 | 0.6 | 0.67 | BBB | 10.0% |
0.6 | 0.4 | 1.50 | C | 12.0% |
0.8 | 0.2 | 4.00 | D | 15.0% |
Elliot uses the CAPM to estimate its cost of the common eqity, rs. The company estimates that the risk-free rate is 5%, the market risk premium is 6%, and its tax rate is 40%. Elliot estimates that if it had no debt, its unlevered beta, bu, would be 1.2. Based on the information, what is the firm’s optimal capital structure, and what would the WACC be at the optimal capital structure?
CLICK HERE FOR THE SOLUTION
