Cerveceria Modelo Company (CMC) has no debt in its capital structure. Currently, due to

some clever tax planning strategies, it pays no corporate income tax. Its equity beta is

estimated to be equal to 1.0. Currently the risk free rate is 5% and the expected return on

the market is 10%.

a) One of the assistants of the CFO suggests that the firm could lower its weighted

average cost of capital (WACC) by borrowing money to finance its operations. Verify

if her assertion is true using a range of 0 to 0.8 for D/V ratio. The firm could issue

debt at 5% (RD). Is there an optimal capital structure?

Hint: You may use the following formula to compute the firm's beta when it uses debt:

L = u [ 1 + (1-T) D/E] where L is the levered beta; u is the asset beta; T is the

corporate tax rate; D/E is the debt equity ratio.

b) Due to a change in government regulations, CMC is likely to lose its tax-exempt

status. Compute RE and WACC for various tax rates starting from zero in steps of 10%

up to 40% (the maximum rate). Does the corporate tax rate influence the cost of

capital and capital structure?

c) Assume the following variations with respect to the base case data:

a. Tax rate = 40%

b. RD = Rf + 0.5 (D/E)

Recalculate RE and WACC. Is there an optimal capital structure at which WACC is

minimised? Comment on your findings.

d) What is the impact of D/E on WACC when:

a. T= 0,

b. As T increases,

c. When debt is risk-free, and

d. When debt is risky.