Spreadsheet Assignment on Capital Structure

Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the companys treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:

Debt-to-Asset Equity-to-AssetsDebt-to-EquityBond RatingBefore-Tax

Ratio Ratio RatioCost of Debt

(w_d)(w_c)(D/E)(r_d)

0.0 1.0 0.00 A 7.0 %

0.2 0.8 0.25 BBB 8.0

0.4 0.6 0.67 BB 10.0

0.6 0.4 1.50 C 12.0

0.8 0.2 4.00 D 15.0

Elliott uses the CAPM to estimate its cost of common equity, r_s. The company estimates that the risk-free rate is 5 percent, the market risk premium is 6 percent, and its tax rate is 40 percent. Elliott estimates that if it had no debt, its unlevered beta, b_u, would be 1.2. On the basis of this information, answer the following questions:

a. What is the firms optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure?

b. Plot on one graph the after-tax cost of debt, the cost of equity, and the WACC versus the debt-to-assets ratio.

c. Would the optimal capital structure change if the unlevered beta changed? To answer this question, do a sensitivity analysis of WACC on b_u for different levels of b_u as follows: 0, 0.6, 1.2, 1.6, and 2.2.

d. Attach a digital copy of your spreadsheet to your report.