Suppose you are the chief financial officer of Toktik Co. and you are trying to determine the optimal capital structure for the company using the cost of capital approach. On the day of this exam, you have collected the following company and market data: The beta of the company is 2.6; 10-year Treasury bond rate is 1.6% and the current market equity risk premium is 6.9%; The companys current bond rating is BB by Standard & Poors; The firm currently has 5.2 billion shares outstanding with share price at $120 and the firms market value of debt is $264 billion The companys marginal tax rate is 35%. Also you are given the following table concerning the latest information on bond rating and the corresponding default spread: Rating Default spread AAA 0.69% AA 0.85% A+ 1.07% A 1.18% A- 1.33% BBB 1.71% BB+ 2.31% BB 2.77% B+ 4.05% B 4.86% B- 5.94% CCC 9.46% CC 9.97% C 13.09% D 17.44% Required: a) Briefly explain, by referencing relevant capital structure theories, the mechanisms through which one can use the cost of capital approach to estimate the optimal capital structure of a company. b) Calculate the after-tax costs of capital for the company in the following alternative capital structure scenarios: Unlevered, when the companys bond rating becomes AAA D/E ratio unchanged Page 5 of 7 MN10500 D/E ratio reduces to 20%, when the companys bond rating becomes A D/E ratio increases to 100%, when the companys bond rating becomes CC Determine which capital combination (unlevered, D/E ratio unchanged, at 20% and 100%, respectively) yields the lowest after-tax cost of capital.