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WACC and optimal capital structure

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Individual Assignment Problem 3 Chapter 21 - Basic Finance by Herbert Mayo

A. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?

B. Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with firm's current balance sheet. What course of action should the firm take?
C. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
_________________________________________________________________________
3. A firm's current balance sheet is as follows:
Assets $100 Debt $10
Equity $90
a. What is the firm's weighted-average cost of capital at various combinations of
debt and equity, given the following information?
Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?

Construct a pro forma balance sheet that indicates the firm's optimal capital
structure. Compare this balance sheet with the firm's current balance sheet.
What course of action should the firm take?

Assets $100 Debt $?
Equity $?

c: As a firm initially substitutes debt for equity financing, what happens to the cost
of capital, and why?
d. If a firm uses too much debt financing, why does the cost of capital rise?

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Solution Summary

The solution explains how to find the optimal capital structure using the WACC and then to prepare a pro-forma balance sheet.

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Elliott Athletics: WACC and Optimal Capital Structure

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16-12 Build a Model - (WACC and Optimal Capital Structure)

Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred 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:

Market debt-to-value Ratio (wd) Market equity-to-value Ratio (Wce) Market debt-to-equity Ratio (D/S) Bond Rating Before-tax Cost of Debt (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

Elliot 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 its tax rate is 40%. Elliot 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 the weighted average cost of capital (WACC) be at the optimal capital structure?

a. Based on this information, what is the firm's optimal capital structure, and what would the weighted average cost of capital be at the optimal structure?

(b) Would the optimal capital structure change if the unlevered beta changed? To answer this question, do a sensitivity analysis of WACC on bU for different levels of bU.

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