Elliott Athletics 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. To estimate how much its debt would cost at different debt levels, the companys treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:

Elliott uses the CAPM to estimate its cost of common equity, r_s, and estimates that the risk-free rate is 5%; the market risk premium is 6%, and its tax rate is 40%. Elliott estimates that if it had no debt, its unlevered beta, b_U, would be 1.2. WACC at the optimal capital structure is 11.45%.

b. If Elliott's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure?

c. If Congreess were to dramatically increase the corporate tax rate, what effect would this likely have on Elliott's target capital structure?

d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus (1) the debt/capital ratio and (2) the debt/equity ratio.

Market Debt- Market Equity- Market Debt- to-Value Ratio to -Value Ratio to-Equity Ratio (wa) (ws) (D/S) 0.0 1.0 0.00 0.2 0.8 0.25 0.4 0.67 0.6 0.4 1.50 0.8 0.2 4.00 Bond Rating A BBB BB D Before-Tax Cost of Debt (ra) 7.0% 8.0 10.0 12.0 15.0 0.6 Market Debt- Market Equity- Market Debt- to-Value Ratio to -Value Ratio to-Equity Ratio (wa) (ws) (D/S) 0.0 1.0 0.00 0.2 0.8 0.25 0.4 0.67 0.6 0.4 1.50 0.8 0.2 4.00 Bond Rating A BBB BB D Before-Tax Cost of Debt (ra) 7.0% 8.0 10.0 12.0 15.0 0.6