Question

Problem 21-05

Given the following, determine the firm’s optimal capital structure:
Debt/Assets   After-Tax Cost of Debt   Cost of Equity
0   %   6   %   11   %
10       6       11  
20       7       11  
30       7       12  
40       9       14  
50       10       15  
60       12       16  
Round your answers for capital structure to the nearest whole number and for the cost of capital to one decimal place.

The optimal capital structure:
% debt and
% equity with a cost of capital of
%

If the firm were using 60 percent debt and 40 percent equity, what would that tell you about the firm’s use of financial leverage? Round your answer for the cost of capital to one decimal place.
If the firm uses 60% debt financing, it would be using financial leverage. At that combination the cost of capital is
%. The firm could lower the cost of capital by substituting .

What two reasons explain why debt is cheaper than equity?
Debt is cheaper than equity because interest expense . In addition, equity investors bear risk.

If the firm were using 20 percent debt and 80 percent equity and earned a return of 9.5 percent on an investment, would this mean that stockholders would receive less than their required return of 11.0 percent?
If the firm earns 9.5% on an investment, the stockholders will earn than their required 11.0%.

What return would stockholders receive? Round your answer to one decimal place.

%

Answer 1

Debt ratio   Cost of Debt   Cost of Equity   WACC
0   6%   11%   11.00%
10   6%   11%   10.50%
20   7%   11%   10.20%
30   7%   12%   10.50%
40   9%   14%   12.00%
50   10%   15%   12.50%
60   12%   16%   13.60%

The optimal capital structure:
20 % debt and
80 % equity with a cost of capital of
10.20 %

If the firm uses 60% debt financing, it would be using more than optimal financial leverage. At that combination the cost of capital is
13.60%. The firm could lower the cost of capital by substituting debt with equity.

Debt is cheaper than equity because interest expense is tax deductible. In addition, equity investors bear risk.

If the firm earns 9.5% on an investment, the stockholders will earn less than their required 11.0%.
Stockholders would receive =(100*9.5%-20*7%)/(100-20)=10.13%