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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 Market Market Bond Before-Tax
Debt-to-value Equity-to-value Debt-to-equity Rating Cost of Debt (rd)
Ratio (wd) Ratio (we) Ratio (D/S)
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 percent, the market risk premium is 6 percent, and its tax rate is 40 percent. Elliott estimates that if it had no debt, its "unlevered" beta, bu, would be 1.2. Based on this information, what is the firms optimal capital structure, and what would be the weighted average cost of capital be at the optimal capital structure?

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Solution Summary

The solution explains the calculation of WACC at different capital structures and selecting the optimal capital structure.