Question
Aaron Athletics is trying to determine its optimal capital structure. The companys capital structure consists of debt and common equity. In order to estimate the
Aaron Athletics is trying to determine its optimal capital structure. The companys capital structure consists of debt and common equity. In order to estimate the cost of capital at various debt levels the company has constructed the following table: Percent financed with debt (wD) Percent financed with equity (ws) Before tax cost of debt 0.10 0.90 7.0% 0.20 0.80 7.2% 0.30 0.70 8.0% 0.40 0.60 8.8% 0.50 0.50 9.6% The company uses the CAPM to estimate its cost of equity, rS . The risk-free rate is 4% and the market risk premium is 5%. Aaron estimates that if it had no debt its beta would be 1.0. (Its unlevered beta equals 1.0). The companys tax rate is 40%. On the basis of this information, what is the companys optimal capital structure, and what is the WACC at that capital structure? (Show your calculations at each debt level). Please show all work.
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