Question

WACC and Optimal Capital Structure F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of low interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: Market Debt- to-Value Ratio (wd) Market Equity-to-Value Ratio (ws) Market Debt- to-Equity Ratio (D/S) Before-Tax Cost of Debt (rd) 0.0 1.0 0.00 7.0% 0.2 0.8 0.25 8.0 0.4 0.6 0.67 10.0 0.6 0.4 1.50 12.0 0.8 0.2 4.00 15.0 F. Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the analaysis the risk-free rate is 6%, the market risk premium is 5%, and the company's tax rate is 40%. F. Pierce estimates that its beta now (which is "unlevered" because it currently has no debt) is 0.9. Based on this information, what is the firm's optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure? Do not round intermediate calculations. Round your answers to two decimal places. DEBT % EQUITY % WACC %

Answer 1

Answer:

Cost of Equity (CAPM) = Risk free rate + Beta * Market risk premium

= 6% + 0.9 * 5%

= 10.50%

WACC = Cost of equity * % Equity + Cost of debt * % Debt

= 10.50% * % Equity + [Before Tax cost of debt * (1 - 40%)] * Debt %

Optimal capital structure is the capital structure where WACC is lowest.

Given:

Now we calculate WACC as per formula given above for possible combinations of debt and equity as follows:

As we observe from table above WACC is lowest at 8.52% when wd = 0.6 and ws = 0.4 (Row highlighted)

Hence optimal capital structure is Debt = 60% and Equity = 40%.

WACC at the optimal capital structure is 8.52%