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WACC and Optimal Capital Structure
F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no
F. Pierce uses the
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Chapter 16 Solutions
Intermediate Financial Management (MindTap Course List)
- 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-ValueRatio(wd) Market Equity-to-ValueRatio(ws) Market Debt-to-EquityRatio(D/S) Before-Tax Cost of Debt (rd) 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 * Use the exact value of 2/3 in your calculations. F. Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the analaysis the risk-free rate is 6%, the market risk premium is 5%, 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 1.25. Based on this information, what is the firm's optimal capital…arrow_forwardWACC AND OPTIMAL CAPITAL STRUCTURE Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firms debt cost at different debt levels: Elliott uses the CAPM to estimate its cost of common equity. rs and estimates that the risk free rate is 5%, the market risk premium is 6%, and its tax rate is 25%. Elliott estimates that if it had no debt, its unleveled beta, bU, would be 1.2. a. What is the firms optimal capital structure, and what would be its WACC at the optimal capital structure? b. If Elliotts managers anticipate that the companys business risk will increase in the future, what effect would this likely have on the firms target capital structure? c. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on Elliotts target capital structure? d. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus (1) the debt/capital ratio and (2) the debt/equity ratio.arrow_forwardTopic: Capital Budgeting and Valuation with Leverage Is it possible to calculate the unlevered value of a firm using the APV method, without knowing the debt level, assuming the growth rate of the EBIT and the interest coverage ratio are constant? I don't think so because then you cannot find the pre-tax WACC. Given information: EBIT FCF Cost of debt CAPM Corporate tax rate Tax paid Interest paid Long-term debtarrow_forward
- The user cost of capital: Consider the basic formula for the user cost ofcapital in the presence of a corporate income tax. Suppose the baseline casefeatures an interest rate of 2 percent, a rate of depreciation of 6 percent, aprice of capital that rises at 1 percent per year, and a 0 percent corporate taxrate. Starting from this baseline case, what is the user cost of capital after thefollowing changes?(a) No changes—the baseline case.(b) Te corporate tax rate rises to 35 percent.(c) Te interest rate doubles to 4 percent.(d) Both (b) and (c).arrow_forwardWhich of the following statements is most correct? Group of answer choices The optimal capital structure maximizes the WACC. None of these. Increasing the amount of debt in a firm's capital structure is likely to increase the cost of both debt and equity financing. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to reduce their WACC by increasing the amount of debt in their capital structure.arrow_forwardDiol Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company’s treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table: Structure Market Debt-to-Value Ratio (Wd) Market Equity-to-Value Ratio (Ws) Bond Rating Pre-tax Cost of Debt (rd) A 0.0 1.0 AA 9.0% B 0.2 0.8 BBB 10.5% C 0.5 0.5 BB 11.6% D 0.6 0.4 C 12.7% E 0.75 0.25 D 14.0% Diol uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free rate is 7%; the market risk is 13%, and the company’s tax rate is 20%. Diol estimates that if it had no debt, its “unlevered” beta, bU, would be 1.3. What is the…arrow_forward
- Which of the following is most correct about the cost of capital? The cost of debt reflects the interest rates on debt capital before taking into account the tax effects. Cost of capital is affected by the required rates of return of each of the source of capital, regardless of the capital structure. The capital asset pricing model is the most widely used model to estimate the cost of common equity. To minimize the cost of capital, firms should borrow more than their capacity because increasing the lower cost of debt yields the lowest cost of capital, thus, enhances shareholder value.arrow_forwardAssume a Modigliani and Miller economy. Company XYZ is currently financed only withequity. The management of the company hires a consultant. The consultant makes thefollowing suggestion: “My advice for XYZ is to issue debt and use it to repurchase some ofthe company’s equity. This would allow XYZ to get the benefit of a low cost of capital ofdebt without raising its cost of capital of equity.”Discuss in detail the statement of the consultant.arrow_forwardOOOO As a financial analyst for a firm looking to make an investment in its operations, you are tasked with determining how upcoming projects are financed. Because the board of directors decided years ago that it would not offer preferred stock, the firm is comprised of only debt and equity financing. Given the following analysis of optional capital Ostructures, which is the optimal capital structure? Proportion of Debt After-Tax Cost Cost of Weighted Financing of Debt Equity Cost 0% 5% 9% 9.00% 10% 5% 9% 8.60% 20% 5% 9% 8.20% 30% 5% 9% 7.80% 40% 5% 10% 8.00% 50% 6% 11% 8.50% 60% 7% 13% 9.40% 70% 10% 17% 12.10% 80% 12% 20% 13.60% 90% 15% 25% 16.00% 100% 18% 25% 18.00% • . O · O 0 a. 30 percent b. 40 percent O c. 100 percent O d. 0 percent Icon Kovarrow_forward
- The Cost of Capital! Check My Work If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt, preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected rate of return is reduced so it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows: Cost of equity from new stock =r, = Pe(1-F) +g The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment. Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $2.40 and it expects dividends to grow at a constant rate g = 4.1%. The firm's current common stock price, Po,…arrow_forwardThe Cost of Capital: Cost of New Common Stock If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt, preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected return is reduced so it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows:The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment. Quantitative Problem: Barton Industries expects next year's annual dividend, D1, to be $1.80 and it expects dividends to grow at a constant rate g = 4.2%. The firm's current common stock price, P0, is $20.60. If it needs to issue new common…arrow_forwardThe WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk. Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%. If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds…arrow_forward
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