Estimate the cost of capital for company A. The company has 4 million shares and 125 000 bonds outstanding at par value $1 000. In addition, it has $20 million in short-term debt from its bank. The target capital structure ratio is 55 percent equity, 40 percent long-term debt, and 5 percent short-term debt. The current capital structure has temporarily moved slightly away from the target ratio. The companys shares currently trade at $50 with a beta of 1.03. The book value of the shares is $16. The annual coupon rate of the bonds is 9 percent, they trade at 108 percent of par, and they will mature in ten years. Interest on the short-term debt is 3.5 percent. The current yield on ten-year government bonds is 5.2 percent. The market risk premium is 5 percent. The corporate tax rate applicable is expected to be 35 percent. Based on these data, calculate the cost of capital for company A. Company A has no debt, and its cost of equity is 14 percent. It can borrow at 8 percent. The corporate tax rate is 40 percent.

1. Calculate the cost of equity and the weighted average cost of capital (WACC) of company A if it decides to borrow up to the equivalent of 25, 50, 75, or 100 percent of its current equity. The proceeds would be used to buy back shares of the company.

2. Draw a graph showing how Company As cost of equity, cost of debt, and WACC vary with the debt-to-equity ratio.

3. On the basis of your results, would you recommend that company A change its capital structure?

Show calculations