Question: You were asked to address the capital structure of your company. Because you know that bankruptcy is always a threat, you commissioned a study to inform you how the cost of equity and debt should look for different debt-to-equity levels. The firm you used came up we the following estimates for a company at your stage and in your line of business:

RD = RUD + (D/E)^5/50 and

RE = RU + (RU RUD) (D/E)

where RUD and RU represent the cost of debt and equity when the firm is unlevered (i.e. when D = 0).

(a) Determine RD and RUD. You can use the Excel solver/goal seek functions or find the value directly using the formulas1 . Note that from the questions above you know the cost of equity and debt for the current D/E value.

(b) Create a table in Excel with the following columns: D/E, Cost of Debt, Cost of Equity, and Cost of Capital

(c) Plot the last three columns as curves depending on D/E.

(d) Estimate the optimal capital structure.

(e) How would you advise the CEO to proceed if issuing and retiring debt and equity incurs in no costs?

(f) Does your answer to the previous question change in the case when issuing and retiring debt and equity incurs in costs?

*****If you were unable to determine the cost of debt and/or equity in the previous question, assume that for a D/E of 1, the cost of debt is 7% and the cost of equity is 14%.

Market-to-Book Ratio 1.25

Income Statement 2015 $43,000,000 Taxes: Sales 40% $30,000,000 COGS Shares outstanding 1,000,000 $5,000,000 Other expenses Depreciation $2,000,000 $6,000,000 EBIT $2,000,000 nterest $4,000,000 Taxable income Taxes (40%) $1,600,000 Net income $2,400,000 Dividends $600,000 Add to RE $1,800,000 Balance Sheet, Dec 31, 2015 Liabilities & Owners' Equity Assets Current Assets Current Liabilities ash $500,000 Accounts Payable $1,000,000 Notes Payable $3,000,000 Accounts Receivable $1,000,000 Inventory $2,000,000 Total CL $4,000,000 Total CA Long Term Debt $10,000,000 $3,500,000 Fixed Assets Owners' Equity Common Stock $6,500,000 Net PP&E $25,000,000 Retained Earnings $8.000,000 Total Equity $141500,000 Total L & O $28.500.000 Total Assets $28.500.000 Income Statement 2015 $43,000,000 Taxes: Sales 40% $30,000,000 COGS Shares outstanding 1,000,000 $5,000,000 Other expenses Depreciation $2,000,000 $6,000,000 EBIT $2,000,000 nterest $4,000,000 Taxable income Taxes (40%) $1,600,000 Net income $2,400,000 Dividends $600,000 Add to RE $1,800,000 Balance Sheet, Dec 31, 2015 Liabilities & Owners' Equity Assets Current Assets Current Liabilities ash $500,000 Accounts Payable $1,000,000 Notes Payable $3,000,000 Accounts Receivable $1,000,000 Inventory $2,000,000 Total CL $4,000,000 Total CA Long Term Debt $10,000,000 $3,500,000 Fixed Assets Owners' Equity Common Stock $6,500,000 Net PP&E $25,000,000 Retained Earnings $8.000,000 Total Equity $141500,000 Total L & O $28.500.000 Total Assets $28.500.000