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A corporation is attempting to find out its optimal capital structure, that now comprise only of debt and common equity. Firm doesn't presently use preferred stock in its capital structure, and it doesn't plan to do so in future. To evaluate how much debt would cost at different debt levels, company's treasury staff has consulted with investment bankers and, on basis of those discussions, has created the table given below:

Debt to Asset Ratio Equity to Asset Ratio Bond Rating Before Tax Cost of Debt
0.0 1.0 A 6.5%
0.2 0.8 BBB 7.5
0.4 0.6 BB 9.5
0.6 0.4 C 10.5
0.8 0.2 D 14.5

Firm utilizes CAPM to evaluate its cost of common equity, ks. Company evaluates that risk free rate is 6 percent, market risk premium (rm - rf ) is 5 percent, and its tax rate is 40 percent. It is also evaluated that if company had no debt, its "unlevered Beta", bU, would be 1.25. On basis of this information, what would be company's optimal debt equity mix and what would weighted average cost of capital (WACC) be at this optimal capital structure? Illustrate your computations and graph to support your answer.

Business Management, Management Studies

  • Category:- Business Management
  • Reference No.:- M935083

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