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Optimal capital structure

Jersey Computer Company has estimated the costs of debt and equity capital (with bankruptcy and agency costs) for various proportions of debt in its capital structure:

Proportion of Debt After-tax Cost Debt, ki After-tax Cost ofEquity, ke
0.00 - 12.0%
0.10 4.7% 12.1
0.20 4.9 12.5
0.30 5.1 13.0
0.40 5.5 13.9
0.50 6.1 15.0
0.60 7.5 17.0

a. Determine the firm's optimal capital structure, assuming a marginal income tax rate (T) of 40 percent.

b. Suppose that the firm's current capital structure consists of 30 percent debt (and 70 percent equity). How much higher is its weighted cost of capital than at the optimal capital structure?

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a. The optimal capital structure would be one that minimizes the weighted average cost of capital and so maximizes the value of firm. Given the proportions of debt, ...

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The solution explains how to determine the optimal capital structure