Question

Problem 21-04

The financial manager of a firm determines the following schedules of cost of debt and cost of equity for various combinations of debt financing:

Debt/Assets		After-Tax Cost of Debt		Cost of Equity
0	%	4	%	8	%
10		4		8
20		4		8
30		5		9
40		6		10
50		8		12
60		10		14
70		12		16

1. Find the optimal capital structure (that is, optimal combination of debt and equity financing). Round your answers for the capital structure to the nearest whole number and for the cost of capital to one decimal place.

   The optimal capital structure: ______% debt and ______% equity with a cost of capital of ______%

Answer 1

Weight of debt (Wd)	After tax cost of debt (Kd)	Weight of equity (We)	Cost of equity (Ke)	Cost of capital= (Wd*Kd)+(We*Ke)
0.00	4	1.00	8	8.0
0.10	4	0.90	8	7.6
0.20	4	0.80	8	7.2
0.30	5	0.70	9	7.8
0.40	6	0.60	10	8.4
0.50	8	0.50	12	10.0
0.60	10	0.40	14	11.6
0.70	12	0.30	16	13.2
The optimal capital structure: 20% debt and 80% equity with a cost of capital of 7.2% (this is optimal structure as cost of capital is lowest in this)