Starline & Co. has no debt, and its cost of equity is 14 percent. It can borrow at 8 percent. The corporate tax rate is 40 percent.
a. Calculate the cost of equity and the weighted average cost of capital (WACC) of Starline if it decides to borrow up to the equivalent of 25, 50, 75, or 100 percent of its current equity. The proceeds would be used to buy back shares of the firm.
b. Draw a graph showing how Starline's cost of equity, cost of debt, and WACC vary with the debt-to-equity ratio.
c. On the basis of your results, would you recommend that Starline change its capital structure?