Question
Company XYZ is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use
Company XYZ is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury staff has consulted with investment bankers. Based on the discussions, the staff has created the following table showing the firm's debt cost at different levels:
Debt to Equity Ratio Bond Rating Before Tax Cost of Debt
0.00 A 7.0%
0.25 BBB 8.0%
0.67 BB 10.0%
1.50 C 12.0%
4.00 D 15.0%
XYZ uses the CAPM to estimate its cost of common equity, rs, and estimates that the risk-free rate is 5%, the market risk premium is 6%, and its tax rate is 40%. XYZ estimates that if it had no debt, its"unlevered"beta, bU, would be 1.2.
QUESTION: Plot a graph of the after tax-cost of debt, the cost of equity, and the WACC versus the debt/equity ratio.
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