Assume that your company is trying to determine its optimal capital structure, which consists only of...

Transcribed Image Text:

Assume that your company is trying to determine its optimal capital structure, which consists only of debt and common stock. To estimate the cost of debt, the company has produced the following table: Percent Financed With Debt Debt/Equity Ratio 0.10 0.20 0.30 0.40 0.50 Percent Financed 9 With Equity 0.90 0.80 0.10/0.90 = 0.11 0.20/0.80 = 0.25 Band Rating AA Before-Tax Cost of Debt 7.0% A 7.2% 0.70 0.30/0.70 = 0.43 A 8.0% 0.60 0.50 0.40/0.60 = 0.67 0.50/0.50 = 1.00 BB 8.8% B 9.6% Now assuine that the company's tax rate is 40 percent, that the company uses the CAPM to estimate its cost of common equity, KS, that the risk-free rate is 5 percent and the market risk premium is 6 percent. Finally assume that if it has no debt its WACC would be equal to its cost of equity which would be equal to 11 percent (you should now be able to determine its "unlevered beta," bu). Given this information, determine the firm's cost of capital if it finances with 40 percent debt and 60 percent equity. 9.26% 9.86% 9.56% 8.96% 10.16% Assume that your company is trying to determine its optimal capital structure, which consists only of debt and common stock. To estimate the cost of debt, the company has produced the following table: Percent Financed With Debt Debt/Equity Ratio 0.10 0.20 0.30 0.40 0.50 Percent Financed 9 With Equity 0.90 0.80 0.10/0.90 = 0.11 0.20/0.80 = 0.25 Band Rating AA Before-Tax Cost of Debt 7.0% A 7.2% 0.70 0.30/0.70 = 0.43 A 8.0% 0.60 0.50 0.40/0.60 = 0.67 0.50/0.50 = 1.00 BB 8.8% B 9.6% Now assuine that the company's tax rate is 40 percent, that the company uses the CAPM to estimate its cost of common equity, KS, that the risk-free rate is 5 percent and the market risk premium is 6 percent. Finally assume that if it has no debt its WACC would be equal to its cost of equity which would be equal to 11 percent (you should now be able to determine its "unlevered beta," bu). Given this information, determine the firm's cost of capital if it finances with 40 percent debt and 60 percent equity. 9.26% 9.86% 9.56% 8.96% 10.16%