Question
Aaron Athletics is trying to determine its optimal capital structure. The companys capital structure consists of debt and common stock. In order to estimate the
Aaron Athletics is trying to determine its optimal capital structure. The companys capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
% Financed with debt (Wd) | Bond Rating | Before tax cost of debt |
0.10 | AA | 7.0% |
0.20 | AA | 7.2 |
0.30 | A | 8.0 |
0.40 | BB | 8.8 |
0.50 | B | 9.6 |
The companys tax rate, T, is 30 percent. The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.2. (i.e., its unlevered beta, bU, equals 1.2.)
On the basis of this information, what is the companys optimal capital structure, and what is the firms cost of capital at this optimal capital structure? (Hint 1: first find the beta at each D/E level using the Hamada equation, then cost of equity at each D/E level using CAPM, then you find WACC at each D/E level. Hint 2: the optimal capital structure is the D/E level with the lowest WACC.)
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