Question

A company has identified the cost of debt and equity for various mixes of the two....

A company has identified the cost of debt and equity for various mixes of the two. The results are provided in the following table:

Cost of Cost of
Percent debt Debt Equity
0.00% 0.00% 15.00%
20.00% 5.00% 16.00%
40.00% 5.50% 18.00%
60.00% 7.00% 23.00%
80.00% 9.00% 31.00%

With this information, what is the optimal mix of debt and equity for this company?

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Answer #1

Optimal capital structure is the combination of debt and equity which minimizes cost of capital, i.e, WACC.

% of Equity = 1-%of Debt

WACC in the absence of taxes is calculated with the following equation

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

% of Debt % of Equity Cost of Debt Cost of Equity WACC
0.00% 100% 0.00% 15% 0*0+15*1 =15%
20% 80% 5% 16% 5*0.20+16*0.80=13.8%
40% 60% 5.5% 18% 5.5*0.40+18*0.60 =13%
60% 40% 7% 23% 7*0.60+23*0.40= 13.4%
80% 20% 9% 31% 9*0.80+31*0.20 =13.4%

WACC is minimum when weight of debt is 40%. Therefore, optimal mix of debt and equity is 40% Debt and 60% Equity.

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