Reacher Technology has consulted with investment bankers and determined the interest rate it would pay for different capital structures, as shown below. Data for the risk-free rate, the market risk premium, an estimate of Reacher's unlevered beta, and the tax rate are also shown below. Based on this information, what is the firm's optimal capital structure and what is the weighted average cost of capital at the optimal structure? Percent Financed with Debt (wa) 0% 5% 10% 15% 20% 30% 35% 40% Before-tax Cost Debt (rd) 6.0% 6.1% 6.3% 6.7% 10.0% 12.5% 15.5% 18.0% 1.0 1.0 0.9 0.9 0.8 0.7 0.7 0.6 Fill in formulas in the yellow cells to find the optimum capital structure. Debt/Value Equity/Value Debt/Equity A-T Cost of Levered Ratio (wa) Ratio (ws) Ratio (wa/ws) Debt (ra) Beta 0% 5% 10% 15% 20% 30% 35% 40% 0.00 0.05 0.11 0.18 0.25 0.43 0.54 0.67 Input Data Risk-free rate Market risk premium Unlevered beta Tax rate WACC at optimum debt ratio Optimum debt ratio 4.5% 5.5% 1.1 25.0% Cost of Equity WACC
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.
Leverage and the Capital Structure. Why is the use of debt financing referred to as financial “leverage?” What is the basic goal of
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