A company is considering its optimal capital structure. The firm currently has 1 million shares outstanding at $ 20 per share (tax rate = 40%) and a debt balance of $5 million. Currently, its (levered) beta is 1.5 and its ERP is 5.5%. The current risk-free rate is 5%. Your research indicate the following ratings and pre-tax cost of debt across the different debt ratios: D/(D+E) Rating Pre-tax cost of debt 0% AAA 10% 10% AA 10.5% 20% A 11% 30% BBB 12% 40% BB 13% 50% B 14% 60% CCC 16% 70% CC 18% 80% C 20% 90% D 25% a. Using the optimal WACC approach, what is the firm's optimal debt ratio? b. Calculate the company's unlevered value, assuming that the probability of default is 5% and the company loses 30% of its value in the event of a default.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
A company is considering its optimal capital structure. The firm currently has 1 million shares outstanding at $ 20 per share (tax rate = 40%) and a debt balance of $5 million. Currently, its (levered) beta is 1.5 and its ERP is 5.5%. The current risk-free rate is 5%. Your research indicate the following ratings and pre-tax cost of debt across the different debt ratios: D/(D+E) Rating Pre-tax cost of debt 0% AAA 10% 10% AA 10.5% 20% A 11% 30% BBB 12% 40% BB 13% 50% B 14% 60% CCC 16% 70% CC 18% 80% C 20% 90% D 25% a. Using the optimal WACC approach, what is the firm's optimal debt ratio? b. Calculate the company's unlevered value, assuming that the probability of default is 5% and the company loses 30% of its value in the event of a default.
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