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?