Hancock Chemicals Co. is trying to determine its optimal capital structure. The companys capital structure consists of debt (D) and common stock (E). In order to estimate the cost of debt (kd ) , the company has produced the table below.

The company uses the CAPM (ke =rf +b (rM -rf ) ) to estimate its cost of common equity, ke. The risk-free rate is 5% and the market risk premium (rM -rf ) is 6%. Hancock estimates that if it had no debt its beta would be 1.0. (Its unlevered beta, bU, equals 1.0.) The companys tax rate, T, is 40%.

On the basis of this information, what is the companys optimal capital structure (B/S), and what is the firms cost of capital (WACC)at this optimal capital structure?

tax rate

40%

Percent financed with debt (w_d)

Percent financed with equity (w_e)

w_d+w_e

Debt-to-equity ratio (B/S)

Bond rating

Before-tax cost of debt (k_d )^*

Cost of equity, k_e

WACC

b _L

k_e

0

1

1

0/1=0

0.00

AAA

7.00%

1.00

0.1

0.9

1

0.10/0.90 = 0.11

0.11

AAA

7.10%

0.2

0.8

1

0.20/0.80 = 0.25

0.25

AA

7.40%

0.3

0.7

1

0.30/0.70 = 0.43

0.43

A

7.90%

0.4

0.6

1

0.40/0.60 = 0.67

0.67

BBB

8.60%

0.5

0.5

1

0.50/0.50 = 1.00

1.00

BB

9.50%

Optimal B/S=
WACC at the optimal B/S=