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1) Sweet Children’s Books is trying to find out its optimal capital structure. Company’s capital structure contains debt and common stock. To evaluate the cost of debt, company has produced the table given below:

% financed        % financed           Debt to Equity   Bond Rating     Before-tax

with debt (Wd)   with equity (Ws)     (D/S)                                 cost of debt (BT Rd)

10%                     90%                   .11                   AAA                   3.0%
20%                     80%                   .25                    AA                    4.0%
30%                     70%                   .43                     A                     4.5%
40%                     60%                   .67                    BB                    5.0%
50%                     50%                   1.0                     B                     6.0%

Company’s tax rate, T, is= 35 percent. Company uses CAPM to evaluate its cost of common equity, Rs. Risk-free rate is 1% and the estimated return on stock market is 6%. Sweet estimates that if it had no debt its beta would be 0.9. (i.e., its “unlevered beta,” bU, equals 0.9.)
On the basis of this information, what is the optimal capital structure of company, and what is the firm’s cost of capital at this optimal capital structure?

Basic Finance, Finance

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