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 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 (w _{d}) |
Market Equity-to-Value Ratio (w _{s}) |
Market Debt-toEquity Ratio (D/S) |
Before-Tax Cost ofDebt (r _{d}) |
||||

0.0 | 1.0 | 0.00 | 6.0 | % | |||

0.10 | 0.90 | 0.1111 | 6.4 | ||||

0.20 | 0.80 | 0.2500 | 7.0 | ||||

0.30 | 0.70 | 0.4286 | 8.2 | ||||

0.40 | 0.60 | 0.6667 | 10.0 |

F. Pierce uses the CAPM to estimate its cost of common equity,
r_{s}, and at the time of the analaysis the risk-free rate
is 5%, the market risk premium is 7%, and the company's tax rate is
25%. F. Pierce estimates that its beta now (which is "unlevered"
because it currently has no debt) is 1.1. 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

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...

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...

Circle Inc. currently uses no debt, but its new CFO is
considering changing the capital structure to 77.5% debt (wd) by
issuing bonds and using the proceeds to repurchase and retire some
common shares so the percentage of common equity in the capital
structure (wc = 1 – wd). Given the data shown below, the cost of
equity under the new capital structure minus the cost of equity
under the old capital structure is _____%. If your answer is 1.23%...

Circle Inc. currently uses no debt, but its new CFO is
considering changing the capital structure to 77.5% debt
(wd) by issuing bonds and using the proceeds to
repurchase and retire some common shares so the percentage of
common equity in the capital structure (wc = 1 –
wd). Given the data shown below, the cost of equity
under the new capital structure minus the cost of equity under the
old capital structure is _____%. If your answer is 1.23%...

Review this situation: Universal Exports Inc. is trying to
identify its optimal capital structure. Universal Exports Inc. has
gathered the following financial information to help with the
analysis.
Debt Ratio
Equity Ratio
rdrd
rsrs
WACC
30%
70%
7.00%
10.50%
8.61%
40%
60%
7.20%
10.80%
8.21%
50%
50%
7.70%
11.40%
8.01%
60%
40%
8.90%
12.20%
8.08%
70%
30%
10.30%
13.50%
8.38%
Which capital structure shown in the preceding table is
Universal Exports Inc.’s optimal capital structure?
____________________
Debt ratio = 60%;...

Adam’s Software Co. is trying to estimate its optimal
capital structure. Right now, Adman has a capital structure that
consists of 20% debt and 80% equity. (Its D/E ratio is 0.25.) %.
Currently the company’s cost of equity is 12% and its tax rate is
40%. The risk-free rate is 6% and the market risk premium is
5%.
What would be Adam’s estimated
cost of equity if it were to change its capital structure to 50%
debt and 50% equity?

WACC Olsen Outfitters Inc. believes that its optimal capital
structure consists of 55% common equity and 45% debt, and its tax
rate is 40%. Olsen must raise additional capital to fund its
upcoming expansion. The firm will have $2 million of retained
earnings with a cost of rs = 15%. New common stock in an amount up
to $9 million would have a cost of re = 19%. Furthermore, Olsen can
raise up to $4 million of debt at an...

1.Transworld Consortium Corp. is trying to
identify its optimal capital structure. Transworld Consortium Corp.
has gathered the following financial information to help with the
analysis.
Debt Ratio (%)
Equity Ratio (%)
rd%rd%
rs%rs%
WACC (%)
30
70
6.02
9.40
9.71
40
60
6.75
9.750
9.55
50
50
7.15
10.60
10.02
60
40
7.55
11.30
10.78
70
30
8.24
12.80
11.45
Which capital structure shown in the preceding table is
Transworld Consortium Corp.’s optimal capital structure?
A) Debt ratio = 40%;...

Cyclone Software Co. is trying to establish its optimal capital
structure. Its current capital structure consists of 20% debt and
80% equity; however, the CEO believes the firm should use more
debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM,
is 5%; and the firm's tax rate is 40%. Currently, Cyclone's cost of
equity is 13%, which is determined by the CAPM.
What would be Cyclone's estimated cost of equity if it changed
its capital structure to...

Cyclone Software Co. is trying to establish its optimal capital
structure. Its current capital structure consists of 40% debt and
60% equity; however, the CEO believes the firm should use more
debt. The risk-free rate, rRF, is 4%; the market risk
premium, RPM, is 5%; and the firm's tax rate is 40%.
Currently, Cyclone's cost of equity is 16%, which is determined by
the CAPM.
What would be Cyclone's estimated cost of equity if it changed
its capital structure to...

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