The Krona Corporation is financed by 50% debt, and 50% equity. Their debt has an 8.5% annual interest rate. Their published Beta Coefficient is 1.57. The Risk Free Rate on U.S. Treasury Securities is 5% and the return on the market portfolio is 10%. Krona is not sure that they have the optimum mix of debt and equity. They are considering the following debt/equity capital structures.
1) Compute Krona's present weighted average cost of capital.
2) Compute the weighted average cost of capital for each potential structure. Assume a 40% corporate tax rate. Should Krona change their capital structure? If so, to which of the following structures? Why? Show your all work.
a) 40% debt with an 8% coupon rate, and 60% equity
b) 60% debt with a 9% coupon rate, and 40% equity
c) 80% debt with a 10% coupon rate, and 20% equity
This solution provides a step-by-step calculation for the weighted average cost of capital of different potential capital structures, given a set interest rate, Beta Coefficient, the risk free rate, and return on market portfolio. From this, the solution explains whether or not the company should change their present capital structure.