Capital Structure

As a firm takes on more debt, its probability of bankruptcy Other factors held constant, a firm whose earnings are relatively volatile faces a chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earnings are relatively volatile should use debt than a more stable firm. When bankruptcy costs become more important, they the tax benefits of debt. Industrialization Automation Co. 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 1.05, and its cost of equity is 12.93%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC also equals 12.93%. The risk-free rate of interest (r is 4%, and the market risk premium (RP) is 8.5%. Industrialization Automation Co.'s marginal tax rate is 40%. Industrialization Automation Co. 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. Before-Tax D/A E/A. Bond Cost of Debt Levered Cost of Ratio Ratio D/E Ratio Rating (ra) Beta (b) Equity (rs) WACC 12.93% 12.93% 0.0 0.00 1.05 14.29% 0.2 0.8 0.25 8.4% 12.44% 16.50% 0.4 0.6 0.67 8.9% 1.47 12.40% 0.6 0.4 50 BB 1.1% 2.00 0.8 0.2 C 14.3% 34.35% 3.57