Capital Structure and Leverage

Corporations are allowed to deduct interest payments as an expense. Corporations are not allowed to deduct dividend payments to stockholders as an expense. The differential tax treatment of interest payments and dividend payments encourages firms to use debt in their capital structure. Debt financing is essexpensive than common or preferred stock financing General Forge and Foundry Corporation currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.1, and its cost of equity is 11.70%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 11.70%. The risk-free rate of interest (Rr) is 496, and the market risk premium (RP) is 7% General Forge's marginal tax rate is 30% General Forge is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table D/A E/A Ratio Ratio D/E Ratio Before-Tax Cost of Debt (rd) Bond Levered Cost of Equity (rs) 1 1.70% 13.03% 15.27% Rating Beta (b) WACC 11.70% 11 .43% 0.00 0.25 0.67 1.50 0.0 0.8 7.2% 0.6 1.61 2.26 4.18 0.6 8.9% 11 .67% 0.8 0.2 11.990 33.26%