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 Debt-to- Market Equity-to- Market Debt-to- Before-Tax Cost Value Ratio (wa) Value Ratio (w,) Equity Ratio (D/S) of Debt (ra) 1.0 0.8 0.0 0.00 6.0% 0.2 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?
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.
F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently
has no debt and no
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 Debt-to-
Value Ratio (wd)
0.0
0.2
0.4
0.6
0.8
Market Equity-to-
Value Ratio (ws)
1.0
0.8
0.6
0.4
0.2
Market Debt-to-
Equity Ratio (D/S)
0.00
0.25
0.67
1.50
4.00
Before-Tax Cost
of Debt (rd)
6.0%
7.0
8.0
9.0
10.0
F. Pierce uses 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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