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Company AAAs capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:

Company AAAs capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:

Percent of debt: (Wd)

Percent of equity: (We)

Bond rating:

Before tax cost of debt: Rd

0.3

0.7

A

8.0%

0.4

0.6

BBB

8.8%

0.5

0.5

BB

9.6%

The companys tax rate is 40% and uses the CAPM to estimate its cost of common equity. The risk-free rate = 5% and the market risk premium = 6%. The company estimates that if it had no debt its beta would be 1.0. (Its unlevered beta equals 1.0). The firm expects zero growth (g=0). The expected FCF (free cash flow) is $100 million per year.

  1. Based on the above information, calculate AAAs optimal capital structure, the cost of capital at this optimal capital structure.
  2. Calculate the firm value at this optimal capital structure.

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