If the firm's tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same? Now consider the case of another company: U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 45%. It currently has a levered beta of 1.10. The risk-free rate is 3.5%, and the risk premium on the market is 8%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 12%. Use the Hamada equation to unlever and relever the beta for the new level of debt. What will the firm's weighted average cost of capital (WACC) be if it make this change in its capital structure?
If the firm's tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same? Now consider the case of another company: U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 10%, and its tax rate is 45%. It currently has a levered beta of 1.10. The risk-free rate is 3.5%, and the risk premium on the market is 8%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 12%. Use the Hamada equation to unlever and relever the beta for the new level of debt. What will the firm's weighted average cost of capital (WACC) be if it make this change in its capital structure?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:If the firm's tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same?
Now consider the case of another company:
U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is
10%, and its tax rate is 45%. It currently has a levered beta of 1.10. The risk-free rate is 3.5%, and the risk
premium on the market is 8%.
U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm's
level of debt will cause its before-tax cost of debt to increase to 12%. Use the Hamada equation to unlever and
relever the beta for the new level of debt. What will the firm's weighted average cost of capital (WACC) be if it makes
this change in its capital structure?
Which of the following statements regarding a firm's optimal capital structure are true? Check all that apply.
The optimal capital structure maximizes the firm's EPS.
O The optimal capital structure minimizes the firm's WACC.
The optimal capital structure minimizes the firm's cost of equity.
The optimal capital structure maximizes the firm's stock price.
The optimal capital structure minimizes the firm's cost of debt.
Transcribed Image Text:9. Determining the optimal capital structure
Aa Aa
Understanding the optimal capital structure
Review this situation: Transworld Consortium Corp. is trying to identify its optimal capital structure. Transworld
Consortium Corp. has gathered the following financial information to help with the analysis.
Debt Ratio Equity Ratio
rd
rs
WACC
30%
70%
6.02%
9.40%
9.71%
40%
60%
6.75%
9.750%
9.55%
50%
50%
7.15%
10.60%
10.02%
60%
40%
7.55%
11.30%
10.78%
70%
30%
8.24%
12.80%
11.45%
Which capital structure shown in the preceding table is Transworld Consortium Corp.'s optimal capital structure?
Debt ratio =
70%; equity ratio = 30%
Debt ratio =
40%; equity ratio = 60%
Debt ratio
60%; equity ratio = 40%
Debt ratio =
50%; equity ratio = 50%
Debt ratio =
30%; equity ratio = 70%
Consider this case:
Globex Corp. currently has a capital structure consisting of 40% debt and 60% equity. However, Globex Corp.'s CFO
has suggested that the firm increase its debt ratio to 50%. The current risk-free rate is 3.5%, the market risk
premium is 8%, and Globex Corp.'s beta is 1.10.
If the firm's tax rate is 45%, what will be the beta of an all-equity firm if its operations were exactly the same?
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