1. La Lluvia Co. 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. Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firm's debt cost at different levels:
|
D/V
|
E/V
|
D/E
|
Beta
|
Rating
|
rd
|
|
0%
|
100%
|
0%
|
1.20
|
A
|
7%
|
|
20%
|
80%
|
25%
|
1.38
|
BBB
|
8%
|
|
40%
|
60%
|
67%
|
1.68
|
BB
|
10%
|
|
60%
|
40%
|
150%
|
2.28
|
C
|
12%
|
|
80%
|
20%
|
400%
|
4.08
|
D
|
15%
|
La Lluvia uses the CAPM to estimate its cost of common equity, rs, and estimates that the risk- free rate is 5%, the market risk premium is 6%, and its tax rate is 40%. La Lluvia estimates that if it had no debt, its beta would be 1.2, but if the company adds debt beta would be higher, like presented in the table above.
a. What is the firm's optimal capital structure, and what would be its WACC at the optimal capital structure? Recall that optimal capital structure is the one that minimizes WACC.
b. If Lluvia's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure?
c. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on Lluvia's target capital structure?
d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus (1) the debt/assets ratio and (2) the debt/equity ratio.
2. Establishment Industries borrows $800 million at an interest rate of 7.6%. It expects to maintain this level of debt into the far future. What is the present value of interest tax shield? Establishment will pay tax at an effective rate of 35%.
3. What is the trade-off theory of capital structure? How does it define the optimal debt ratio?
4. What is the pecking order theory of capital structure? If the theory is correct, what types of firms would you expect to operate at high levels of debt?
5. Why is financial slack valuable? (Hint: What does the pecking order say about financial slack? Are there circumstances where too much financial slack might actually reduce the market value of the firm?