Problem 2

Recently, your boss, the CFO of Conservative Corp. came across the notion that adjusting the firms capital structure might significantly decrease the cost of capital and therefore increase the value of the company. Your boss has asked you to do a preliminary study on this issue. Conservative Corp. currently has a very conservative leverage policy with D/E ratio of only 10%. Regressions of the past 5 years data result in an estimated equity beta of 1.07. The marginal tax rate is 40%. The long- term risk-free rate is 8% and the market risk premium is 5,5%. An investment banker recently estimated the pretax cost of debt at various levels Wd and the estimates are as follows.

Percent Financed with Debt (wd)

0% 10% 20% 30% 40% 50% 60% 70%

1. What is

2. What is

Before-tax Cost Debt (rd)

5,0% 6,0% 7,0% 8,0% 9,5%

10,0% 11,5% 18,0%

the weighted cost of capital (WACC) today when the Wd is 10%? the unlevered beta of the firm today?

3. Construct a table showing the values of the betas of equity, the costs of equity

   and the WACCs for all Wd values

4. What is the optimal capital structure for the firm? What is the minimum WACC?