Question

Aaron Athletics is trying to determine its optimal capital structure. The company’s capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:

Debt-to-total-             Equity-to-total-              Debt-to-equity           Bond       B-T cost

assets ratio (w_d)          assets ratio (w_c)               ratio (D/E)                rating      of debt

                                                                                                                                              

0.10                            0.90                      0.10/0.90 = 0.11         AA      7.0%

0.20                            0.80                      0.20/0.80 = 0.25           A        7.2

0.30                            0.70                      0.30/0.70 = 0.43           A        8.0

0.40                            0.60                      0.40/0.60 = 0.67          BB       8.8

0.50                            0.50                      0.50/0.50 = 1.00           B        9.6

The company’s tax rate, T, is 40 percent.

The company uses the CAPM to estimate its cost of common equity, k_s. The risk-free rate is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (Its “unlevered beta,” b_U, equals 1.0.)

On the basis of this information, what is the firm’s weighted average cost of capital (WACC) at its optimal capital structure?

Answer 1

Weighted average cost of capital at optimal capital structure is 10.152%