Question

B.F. Pierce & Company is considering changing its capital structure. The company 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	Market Equity-to-Value Ratio	Market Debt-to-Equity Ratio	Before-Tax Cost of Debt
(wD)	(wE)	(D/E)	(rD)
0.00	1.00	0.00	4.00%
0.20	0.80	0.25	6.00%
0.40	0.60	0.67	8.00%
0.60	0.40	1.50	10.00%
0.80	0.20	4.00	12.00%

The company uses the CAPM to estimate its cost of common equity. Currently the risk-free rate is 5%, the market risk premium is 6%, and the company’s tax rate is 35%. The company estimates that its beta now (which is unlevered because it currently has no debt) is 0.8. Based on this information, what is the firm’s weighted average cost of capital at its optimal capital structure?

Group of answer choices

8.66%

9.07%

9.21%

8.83%

Answer 1