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    Elliott Athletics is trying to determine its optimal capital

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    Elliott Athletics is trying to determine its optimal capital structure, whick now consists of only debt and common equity. The firm does not currently use perferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company's treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:

    Problem attachment for WACC and Optimal Capital Structure

    Market Debt- Market Equity Market Debt Bond Before-tax
    To value Ratio To value Ratio to Equity Ratio rating Cost of Debt
    Wd Ws (d/s) Rd
    0.0 1.0 0.00 A. 7.0%
    0.2 0.8 0.25 BBB 8.0
    0.4 0.6 0.67 BB 10.0
    0.6 0.4 1.50 C 12.0
    0.8 0.2 4.00 D 15.0

    Elliott uses the CAPM to estimate its cost of common equity, Rs. The company estimates that the risk-free rate is 5%; the market risk premium is 6%, and the company's tax rate is 40%. Elliott estimates that if it had no debt, its "unlevered" beta, Bu, would be 1.2. Based on this information, what is the firm's optimal capital structure, and what would be the WACC at the optimal capital structure?

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    Solution Summary

    Elliott Athletics is trying to determine its optimal capital structure, whick now consists of only debt and common equity. The firm does not currently use perferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company's treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:

    Problem attachment for WACC and Optimal Capital Structure

    Market Debt- Market Equity Market Debt Bond Before-tax
    To value Ratio To value Ratio to Equity Ratio rating Cost of Debt
    Wd Ws (d/s) Rd
    0.0 1.0 0.00 A. 7.0%
    0.2 0.8 0.25 BBB 8.0
    0.4 0.6 0.67 BB 10.0
    0.6 0.4 1.50 C 12.0
    0.8 0.2 4.00 D 15.0

    Elliott uses the CAPM to estimate its cost of common equity, Rs. The company estimates that the risk-free rate is 5%; the market risk premium is 6%, and the company's tax rate is 40%. Elliott estimates that if it had no debt, its "unlevered" beta, Bu, would be 1.2. Based on this information, what is the firm's optimal capital structure, and what would be the WACC at the optimal capital structure?

    $2.19