Question
WACC and Optimal Capital Structure - Structure consists of only debt and common equity. The company's finance dept has created the following table showing the
WACC and Optimal Capital Structure - Structure consists of only debt and common equity.
The company's finance dept has created the following table showing the company's debt cost at different debt levels. The company uses the CAPM to estimate its cost of common equity and estimates that the risk-free rate is 4%, the market risk premium is 7%, and its tax rate is 35%. The company estimates that if it had no debt, its "unlevered" beta would be 1.5. 1) What would be its WACC at the optimal capital structure? What would the company's optimal capital structure be? 2) If the company's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the company's target capital struture? 3) If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on the company's taret capital structure?
Debt-to-Capital Ratio | Equity-to-Capital Ratio | Debt-to-Equity Ratio | Bond Rating | Before-Tax Cost of Debt |
0.0 | 1.0 | 0.00 | A | 6.0% |
0.2 | 0.8 | 0.25 | BBB | 7.0% |
0.4 | 0.6 | 0.67 | BBB | 9.0% |
0.6 | 0.4 | 1.50 | C | 11.0% |
0.8 | 0.2 | 4.00 | D | 14.0% |
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