River Cruises' management now understands that the trade-off theory of optimal capital structure implies managers will increase debt as long as the value of additional interest tax shields exceeds the additional costs of potential financial distress. This trade-off gives rise to the hump-shaped curve in Figure 16.7, where the value of the firm is maximized at the optimal debt level. What will the curve of WACC as a function of debt level look like?
Figure 16.7 The trade-off theory of capital structure. The curved blue line shows how the market value of the firm at first increases as the firm borrows but finally decreases as the costs of financial distress become more and more important. The optimal capital structure balances the costs of financial distress against the value of the interest tax shields generated by borrowing.

a. Start with a no-tax economy. Continue to assume that River Cruises' required return on assets is 12.5% and return on debt is 10%. In a spreadsheet, calculate requity, WACC, and rdebt for debt-equity ratios ranging from 0 to 2.5 in increments of .1. Does WACC vary with the D/E ratio? Compare your plot to Figure 16.3.
FIGURE 16.3 MM's proposition II with a fixed interest rate on debt. The expected return on River Cruises' equity rises in line with the debt-equity ratio. The weighted average of the expected returns on debt and equity is constant, equal to the expected return on assets.

b. Now assume the corporate tax rate is 35%. Repeat part (a). What happens to WACC as D/E increases?
c. What seems to be the optimal capital structure?

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PV costs of financlal distress sbleld Value if all-equity- financed Debt ratio 18 16 14 epeced return on equity assots-expected return on assets S 10 rdabt return on debt 0 0.1 0.2 0.3 0.4 05 0.6 0.7 0.8 0.9 1.1 1.2 1.3 1.4 1.5 1.6 Debt-equity ratio, DyE