River Cruises' management now understands that the trade-off theory of optimal capital structure implies managers will increase debt as long as the value of additional interest tax shields exceeds the additional costs of potential financial distress. This trade-off gives rise to the hump-shaped curve in Figure 16.7, where the value of the firm is maximized at the optimal debt level. What will the curve of WACC as a function of debt level look like?
a. Start with a no-tax economy. Continue to assume that River Cruises' required return on assets is 12.5% and return on debt is 10%. In a spreadsheet, calculate requity, WACC, and rdebt for debt-equity ratios ranging from 0 to 2.5 in increments of .1. Does WACC vary with the DIE ratio? Compare your plot to Figure 16.3.
b. Now assume the corporate tax rate is 35%. Repeat part (a). What happens to WACC as DIE increases? What seems to be the optimal capital structure?
c. What considerations are missing that would affect the optimal capital structure seemingly implied by part (b)?

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18 16 14 12 2 10 equity-expected return on equity Fassets-expected return on assets debt-return on debt 0.10.2 0.3 0.4 0.5 0.6 0.7 08 0.9 1 1.1 1.21.3 1.4 15 16 Debt-equity ratio, DIE