Timberland Inc., a manufacturer and retailer of footwear and sportswear, is considering is highly levered status. In 1995, the firm had $ 237 million in market value of debt outstanding, and 11 million shares outstanding at $ 19.88 per share. The firm had earnings before interest and taxes of $ 44 million, a book value of capital of $ 250 million and a tax rate of 37%. The treasury bond rate is 7.88%, and the stock has a beta of 1.26.

The following table summarizes the estimated bond ratings and interest rates at different levels of debt for Timberland.

a. Estimate the optimal debt ratio, using the cost of capital approach.

b. Estimate the optimal debt ratio, using the return differential approach.

c. Will the two approaches always give you identical results? Why or why not?

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Debt Ratio 0% Bond Rating AAA Interest Rate on Debt 8.18% 10% AAA 8.18% 20% A+ 8.88% 30% A 9.13% 40% A- 9.38% 50% BB 10.38% 60% BB 10.38%