Estimating the Optimal Capital Structure

Pier 12 is trying to estimate its optimal capital structure. It currently is financed with 80% equity. Its expected EBIT is $200M. Pier 12 expects no growth. Its combined tax rate is 40%. Its beta is .9. The risk-free rate is 2% and the market risk premium is 4%. Investment bankers for Pier 12 estimated the firms cost of debt under a variety of debt levels as shown in the table below:

Weight of Debt (Wd)	Cost of Debt (rd)
10%	4.5%
20%	5.0%
30%	5.0%
40%	6.5%
50%	8.0%

Step One Estimate its cost of equity at each of these debt levels.

Step Two Estimate its weighted average cost of capital at each of these debt levels.

Step Three Estimate the value of the firm at each of these debt levels.

Step Four Estimate the value of debt and the value of equity at the optimal debt level.