Rebecca Isbell Optical Corporation is trying to determine an appropriate capital structure. It knows that, as its financial leverage increases, its cost of borrowing will eventually increase as will the required rate of return on its common stock. The company has made the following estimates for various financial leverage ratios.

a. At a tax rate of 50 percent, what is the weighted average cost of capital of the company at various leverage ratios in the absence of bankruptcy costs?
b. With bankruptcy costs, what is the optimal capital structure?

Transcribed Image Text:

REQUIRED RATE OF RETURN ON EQUITY DEBT DIVIDED BY (DEBT + EQUITY) INTEREST RATE ON BORROWİNGS WITHOUT BANKRUPTCY WITH BANKRUPTCY Cosrs 10.00% 10.50 11.00 11.50 12.25 CosTs 10.00% 0.10 0.30 0.50 8.0% 8.0 10.0 11.0 12.5 15.0 11.25 12.00 13.00 14.50 16.25 18.50 21.00 14.50 16.00 18.00