Question

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)

Answer #1

Plan B creates the lowest cost of capital

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Compute the firm’s new equity beta and...

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An analyst is trying to determine the optimal capital structure
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Structure A
Structure B
Structure C
Structure D
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$0
$5,000
$10,000
$15,000
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$15,000
$10,000
$5,000
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Chapter 10 Question 1
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