Concept explainers
Capital Structure of any company is the mix of different levels of debt and equity. An optimal capital structure is the appropriate mix of debt and equity, striking a balance between risk and return to achieve the goal of maximizing the price of the firm’s stock. Therefore, a target proportion of capital structure and cost of each financing can be used to determine the WACC of the company.
Weighted Average Cost of Capital (WACC) is the required
Here,
Proportion of debt in the target capital structure “
Proportion of preferred stock in the target capital structure “
Proportion of equity in the target capital structure “
After tax cost of debt, preferred stock,
EPS analysis at a given level of EBIT helps in determining the optimal capital structure of the firm, that is the structure at which the EPS will be the highest.
The company has $6 million in assets, $700,000 as EBIT, 80,000 shares outstanding. If the debt to total asset is 70%, the interest rate is 12% however, if the debt to total asset is 40%, the interest rate lowers to 9%. The marginal tax rate is 40%.
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Check out a sample textbook solution- Fama’s Llamas has a weighted average cost of capital of 8.4 percent. The company’s cost of equity is 11 percent, and its pretax cost of debt is 5.8 percent. The tax rate is 25 percent. What is the company’s target debt-equity ratio? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.)arrow_forwardFama's Llamas has a weighted average cost of capital of 9.4 percent. The company's cost of equity is 13 percent, and its pretax cost of debt is 6.7 percent. The tax rate is 22 percent. What is the company's target debt-equity ratio? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., .1616.) L Debt-equity ratioarrow_forwardFama’s Llamas has a weighted average cost of capital of 10.4 percent. The company’s cost of equity is 13 percent and its pretax cost of debt is 7.9 percent. The tax rate is 24 percent. What is the company's debt-equity ratio? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.) Debt-equity ratio:______?arrow_forward
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- What is Sultan Incorporated’s WACC (in percent to two places) if it has $15,507 with 9% after-tax cost of debt, $8,265 with 7% cost of preferred, and $10,019 with 13% cost of equity.arrow_forwardBolero Corporation has one long term loan (interest bearing debt) of $700,000 at an interest rate of 8%. The company has accounts payable of $300,000 (non-interest bearing) and equity of $1,000,000. It estimates that its cost of equity is 16%. Its tax rate is 35%. A. What is the company’s weighted average cost of capital on interest bearing debt and equity? B. What is Bolero Corporation’s weighted average cost of capital on all liabilities and equity (or total invested capital)?arrow_forwardAEI Incorporated has $5 billion in assets, and its tax rate is 40%. Its basicearning power (BEP) ratio is 10%, and its return on assets (ROA) is 5%. What is AEI’s times interest-earned (TIE) ratio?arrow_forward