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Optimal Capital Structure and Average Cost of Capital

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The Cost of Capital
Canyon Drilling, Inc. has just come under new management. One of the first things the new management wants to accomplish is to identify its capital structure and the cost of additional funding, if needed.
According to the accounting department, the current balance sheet is accurate and reflects the financial structure of the company. They have also calculated the marginal tax rate to be 40%. The company's beta is currently 1.15.
Company Specifics

3,600 par value ($1,000) bonds outstanding. All have a 7% coupon, and will mature in 20 years. Market value is currently $1,050 and interest is paid once a year.
Common Stock
The company has 40,000 shares of common stock outstanding, and has a market price of $50 per share. The stock last paid a dividend of $1.40 and had a constant growth of 5% per year.

Preferred Stock
The company has 7,500 shares of 5% preferred stock outstanding. All have $100 par value and are selling for $80 per share.

Floatation costs: Debt = 4%, Equity = 5%

Market Specifics

Market risk premium = 7%
Risk free rate = 4%
Return on the average stock = 11%

• Assuming the same capital structure is to be maintained, what is the optimal capital structure for Canyon Drilling?
• What is the component cost of capital for the firm?
• Calculate Canyon Drilling's after tax weighted average cost of capital, using the information above.
• Please give an executive summary of your findings

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Solution Summary

The optimal capital structures and average cost of capitals are examined.

Solution provided by:
  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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