WACC and Optimal Capital Structure F. Pierce Products Inc. is considering changing its capital structure. F. Pierce...

80.2K

Verified Solution

Question

Finance

WACC and Optimal Capital Structure
F. Pierce Products Inc. is considering changing its capitalstructure. F. Pierce currently has no debt and no preferred stock,but it would like to add some debt to take advantage of lowinterest rates and the tax shield. Its investment banker hasindicated that the pre-tax cost of debt under various possiblecapital structures would be as follows:
Market Debt-
to-Value
Ratio (w_d) Market Equity-to-Value
Ratio (w_s) Market Debt-
to-Equity
Ratio (D/S) Before-Tax Cost of Debt(r_d)
0.0 1.0 0.00 7.0%
0.2 0.8 0.25 8.0
0.4 0.6 0.67 10.0
0.6 0.4 1.50 12.0
0.8 0.2 4.00 15.0
F. Pierce uses the CAPM to estimate its cost of common equity,r_s and at the time of the analaysis the risk-free rateis 7%, the market risk premium is 6%, and the company's tax rate is30%. F. Pierce estimates that its beta now (which is "unlevered"because it currently has no debt) is 1.4. Based on thisinformation, what is the firm's optimal capital structure, and whatwould be the weighted average cost of capital at the optimalcapital structure? Do not round intermediate calculations. Roundyour answers to two decimal places.
DEBT %
EQUITY %
WACC %

Answer & Explanation Solved by verified expert

4.1 Ratings (720 Votes)

Tax rate T 30 Risk free rate rf 7 market risk premium rp 6 Unlevered beta Bu 14 Levered beta B Bu x 1 1 T x D S 14 x 1 1 30 x D S Cost of equity rs See Answer

Get Answers to Unlimited Questions

Join us to gain access to millions of questions and expert answers. Enjoy exclusive benefits tailored just for you!

Membership Benefits:

Unlimited Question Access with detailed Answers
Zin AI - 3 Million Words
10 Dall-E 3 Images
20 Plot Generations
Conversation with Dialogue Memory
No Ads, Ever!
Access to Our Best AI Platform: Flex AI - Your personal assistant for all your inquiries!

Become a Member

Transcribed Image Text

WACC and Optimal Capital StructureF. Pierce Products Inc. is considering changing its capitalstructure. F. Pierce currently has no debt and no preferred stock,but it would like to add some debt to take advantage of lowinterest rates and the tax shield. Its investment banker hasindicated that the pre-tax cost of debt under various possiblecapital structures would be as follows:Market Debt-to-ValueRatio (wd)Market Equity-to-ValueRatio (ws)Market Debt-to-EquityRatio (D/S)Before-Tax Cost of Debt(rd)0.01.00.007.0%0.20.80.258.0 0.40.60.6710.0 0.60.41.5012.0 0.80.24.0015.0 F. Pierce uses the CAPM to estimate its cost of common equity,rs and at the time of the analaysis the risk-free rateis 7%, the market risk premium is 6%, and the company's tax rate is30%. F. Pierce estimates that its beta now (which is "unlevered"because it currently has no debt) is 1.4. Based on thisinformation, what is the firm's optimal capital structure, and whatwould be the weighted average cost of capital at the optimalcapital structure? Do not round intermediate calculations. Roundyour answers to two decimal places.DEBT%EQUITY%WACC%

Market Debt- to-Value Ratio (w_d)	Market Equity-to-Value Ratio (w_s)	Market Debt- to-Equity Ratio (D/S)	Before-Tax Cost of Debt(r_d)
0.0	1.0	0.00	7.0%
0.2	0.8	0.25	8.0
0.4	0.6	0.67	10.0
0.6	0.4	1.50	12.0
0.8	0.2	4.00	15.0