Question

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	0.00	6.0%
0.2	0.8	0.25	7.0
0.4	0.6	0.67*	8.0
0.6	0.4	1.50	9.0
0.8	0.2	4.00	10.0

* Use the exact value of 2/3 in your calculations.

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 6%, and the company's tax rate is 40%. F. Pierce estimates that its beta now (which is "unlevered" because it currently has no debt) is 1.4. 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

Answer:

We calculate below the following:

After Tax cost of debt = Before Tax Cost of Debt (r_d) * (1 - Tax rate) = rd * (1-40%)

Levered Beta =ßL = Unlevered Beta + Unlevered Beta * Debt / Equity * (1 - Tax rate) = ßU +ßU * Debt/Equity * (1-Tax)

Cost of Equity = Risk free rate + Levered beta * Market risk premium = 5% + ßL * 6%

WACC = Cost of equity * Weight + After tax Cost of debt * Weight

Calculations are tabulated below:

We observe from above table minimum WACC = 11.51% and optimum capital structure is

Debt: 80 %
Equity: 20%
WACC: 11.51%