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F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to
F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no
debt and no preferred stock, but it would like to add some debt to take advantage of low
interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of
debt under various possible capital structures would be as follows:
Market Debt-to-
Value Ratio (wd)
Market Equity-to-
Value Ratio (ws)
Market Debt-to-
Equity Ratio (D/S)
Before-Tax Cost of
Debt (rd)
0.0 1.0 0.00 6.0%
0.2 0.8 0.25 7.0
0.4 0.6 0.67 8.0
0.6 0.4 1.50 9.0
0.8 0.2 4.00 10.0
F. Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the
analysis the risk-free rate is 5%, the market risk premium is 6%, and the companys tax rate is
40%. F. Pierce estimates that its beta now (which is unlevered because it currently has no
debt) is 0.8. Based on this information, what is the firms optimal capital structure, and what
would be the weighted average cost of capital at the optimal capital structure?
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