F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of low interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: Market Equity-to- Value Ratio (w,) Market Debt-to- Market Debt-to- Before-Tax Cost Value Ratio (wa) Equity Ratio (D/S) of Debt (ra) 0.0 1.0 0.00 6.0% 0.2 0.8 0.25 7.0 0.4 0.6 0.67 8.0 0.6 0.4 1.50 9.0

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
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Chapter1: Investments: Background And Issues
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(15-11)
WACC and Optimal
Capital Structure
F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently
has no debt and no preferred stock, but it would like to add some debt to take
advantage of low interest rates and the tax shield. Its investment banker has indicated
that the pre-tax cost of debt under various possible capital structures would be as
follows:
Before-Tax Cost
Market Equity-to-
Value Ratio (w,)
Market Debt-to-
Market Debt-to-
Value Ratio (wa)
Equity Ratio (D/S)
of Debt (ra)
0.0
1.0
0.00
6.0%
0.2
0.8
0.25
7.0
0.4
0.6
0.67
8.0
0.6
0.4
1.50
9.0
0.8
0.2
4.00
10.0
F. Pierce uses the CAPM to estimate its cost of common equity, r, and at the time of the
analysis the risk-free rate is 5%, the market risk premium is 6%, and the company's tax
rate is 40%. F. Pierce estimates that its beta now (which is "unlevered" because it
currently has no debt) is 0.8. Based on this information, what is the firm's optimal
capital structure, and what would be the weighted average cost of capital at the optimal
capital structure?
Transcribed Image Text:(15-11) WACC and Optimal Capital Structure F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of low interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: Before-Tax Cost Market Equity-to- Value Ratio (w,) Market Debt-to- Market Debt-to- Value Ratio (wa) Equity Ratio (D/S) of Debt (ra) 0.0 1.0 0.00 6.0% 0.2 0.8 0.25 7.0 0.4 0.6 0.67 8.0 0.6 0.4 1.50 9.0 0.8 0.2 4.00 10.0 F. Pierce uses the CAPM to estimate its cost of common equity, r, and at the time of the analysis the risk-free rate is 5%, the market risk premium is 6%, and the company's tax rate is 40%. F. Pierce estimates that its beta now (which is "unlevered" because it currently has no debt) is 0.8. Based on this information, what is the firm's optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure?
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