You have been asked to analyze the capital structure of Stevens Steel, a small steel company. The company has supplied you with the following information:

There are 100 million shares outstanding, trading at $ 10 a share

The firm has debt outstanding of $ 500 million, in market value terms.

The beta for the firm currently is 1.04, the risk free rate is 5% and the market risk premium is 5.5%.

The firms current bond rating is A; the default spread for A rated bonds is 1.5%.

The marginal tax rate is 40%.

a. Estimate the current cost of capital for Stevens Steel.

b. Now assume that you have computed the optimal debt to capital ratio to be 50%. If the pre-tax cost of debt will rise by 0.25% if it moves to the optimal, estimate the new cost of capital at 50%.

c. Estimate the new number of shares, assuming that you are planning to borrow money and buy back stock, and that you can buy the stock back at an average price of $ 11.50.

a.

a) 8.99% b) 7.25% c) 65.45 millions

b.

a) 3.33% b) 4.55% c) 33.33 millions

c.

a) 6.55% b) 9.89% c) 118.26 millions

d.

a) 8.45% b) 8.05% c) 78.26 millions

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