Question

Problem 21-05

1. Given the following, determine the firm’s optimal capital structure:

   Debt/Assets		After-Tax Cost of Debt		Cost of Equity
   0	%	6	%	13	%
   10		6		13
   20		7		13
   30		7		13
   40		9		14
   50		10		15
   60		12		16

   Round your answers for 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 _____%

2. If the firm were using 10 percent debt and 90 percent equity, what would that tell you about the firm’s use of financial leverage? Round your answer for the cost of capital to one decimal place.

   If the firm uses 10% debt financing, it would be using too little financial leverage. At that combination the cost of capital is ______%. The firm could lower the cost of capital by substituting debt for equity.

3. If the firm were using 30 percent debt and 70 percent equity and earned a return of 11.5 percent on an investment, would this mean that stockholders would receive less than their required return of 13.0 percent?

   If the firm earns 11.5% on an investment, the stockholders will earn more than their required 13.0%.

   What return would stockholders receive? Round your answer to one decimal place.

   ________ %

Answer 1

				A	B	A + B
Debt/Assets	Equity/Assets	After-Tax Cost of Debt	Cost of Equity	(Debt/Assets) * After tax cost of debt	(Equity/Assets) * Cost of Equity	WACC
0%	100%	6%	13%	0.0%	13.0%	13.0%
10%	90%	6%	13%	0.6%	11.7%	12.3%
20%	80%	7%	13%	1.4%	10.4%	11.8%
30%	70%	7%	13%	2.1%	9.1%	11.2%
40%	60%	9%	14%	3.6%	8.4%	12.0%
50%	50%	10%	15%	5.0%	7.5%	12.5%
60%	40%	12%	16%	7.2%	6.4%	13.6%
The optimal capital structure: 30% debt and 70% equity with a cost of capital of 11.2%