Ace Enterprises Limited is a large company involved in production and sale of petroleum products. The Finance Department of the company is trying to determine the company’s optimal capital structure. The firms’ financial advisors have developed the following table: Equity-Ratio Debt-Ratio Before Tax Cost of Debt (Kd) 100% 0% 7.00% 80% 20% 8.00% 60% 40% 10% 40% 60% 12% 20% 80% 15% The company uses and applies the Capital Assets Pricing Model to estimate its cost of common equity. The company estimates that the risk free rate is 4.0%. The market risk premium is 6.0%, and its tax rate is 30 percent. The company estimates that if it had no debt, its unlevered beta would be 1.2. Required: A. Based on the above information, what is the firm’s optimal capital structure? B. What would the weighted average cost of capital be at the optimal capital structure? C. If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?
Ace Enterprises Limited is a large company involved in production and sale of petroleum
products. The Finance Department of the company is trying to determine the company’s
optimal capital structure. The firms’ financial advisors have developed the following table:
Equity-Ratio Debt-Ratio Before Tax Cost of Debt (Kd)
100% 0% 7.00%
80% 20% 8.00%
60% 40% 10%
40% 60% 12%
20% 80% 15%
The company uses and applies the
would be 1.2.
Required:
A. Based on the above information, what is the firm’s optimal capital structure?
B. What would the weighted average cost of capital be at the optimal capital structure?
C. If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?
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