Question

Question 2 (5 points) Athletics is trying to determine its optimal capital structure. The company's capital ructure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table: Percent financed P ercent financed Debt-to-equity ratio Bond Before-tax cost with equity (We) of debt rating (D/S) 0.20/0.80 = 0.25 AA 0.30/0.70 = 0.43 0.40/0.60 = 0.67 BBB with debt (wa) 0.20 0.30 0.40 7.0 7.5 8.2 0.80 0.70 0.60 The company uses the CAPM to estimate its cost of common equity, I's. The is 4% and the market risk premium is 5%. Aaron estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bu, equals 1.0.) The company's tax rate, 1, 153 On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Answer 1

Given,

Risk free rate = 4%

Market risk premium = 5%

Tax rate = 30%

Unlevered beta = 1.0

Solution :-

Step 1 - Calculation of betat i Formula . beta - Unlevered x/1+ (1-t) Debt-equity) beta t ratio I Tax Debt - equity ratio date Tt Unlevered beta Betalß) 0.25 30% 10 1.175 0.43 30% 1.301 O. 67 30% 1.469 Step 2 - Calculation of cost of equity Formwa Using (Apm Cost of equity & Rp + B (market disk Pornim wheze, Rp 2 Risk free rate B = beta

Risk free (B) Market date beta | sisk Bemium Cost of equity 11.125 9.875% 1.301 I SY. 10.505 % 1.469 I S% 11.345 % Step 3 – I A Bond I wa rating B Calculate WACC + C D After tax Cost Cost of of debt I equity (AXC) + (BxD) WACE AA 0.20 0.80 4.9% 9.875% 8.88% 0. 30 0.70 5.254. 10. Sosy. 8.93% BBB 0.40 0.60 5.74% 11.345% 9.12%

Bond rating At has WACC of 8.88% which low as compared to others. Against this WACC, weight of debt is 0.20 0.80. and weight of equity is This is the company's optimal Capital Structure. And, At Structure, 8. 88 % this fiom's Optimal cost of Capital capital is