Question

A firm has an unlevered beta of 1.10. Assume that the tax rate is 25%, the risk free rate is 3% and the expected return on the market is 9.5%. Determine the optimal capital structure for a company based on the following information:

Leverage (Debt/Assets)	Credit Rating	Yield to Maturity (Before Tax)
10%	AAA	2.2%
20%	AA	2.5%
30%	AA-	2.9%
40%	A	3.6%
50%	BBB	4.6%
60%	BBB-	5.75%
70%	BB	6.95%
80%	B-	8.85%
90%	CCC-	11.0%

Please show calculations and formulas as would be prepared on spreadsheet.

Answer 1

Optimal capital structure means a combination of debt and equity in capital structure which gives lowest weighted average cost of capital. The goal of management of company is to minimize the WACC of the company.

WACC of company at each level of debt assets ratio and optimal capital structure is calculated in excel and screen shot provided below:

Optimal Capital structure is 40% debt and 60% equity and WACC is 9.099%.