Question

A firm has an equity beta of 1.28. Currently, the market value of the firm’s debt...

A firm has an equity beta of 1.28. Currently, the market value of the firm’s debt is $10.00 million, while the market value of the firm’s equity is $30.00 million. The firm is considering adjusting their capital structure by either paying down debt or issuing additional debt. They want to consider the options.

The firm faces a tax rate of 40.00%. The risk free rate in the economy is 2.00%, while the market portfolio risk premium is 6.00%. The cost of debt for the firm depends on the capital structure as shown below:

D/E Structure: Debt Equity Yield on Debt
A $0.00 $40.00 6.52%
B $10.00 $30.00 6.77%
C $20.00 $20.00 7.27%

Which capital structure creates the lowest cost of capital? (A,B, or C)

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Plan B creates the lowest cost of capital

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