Fundamentals of Financial Management, Concise Edition (MindTap Course List)
Fundamentals of Financial Management, Concise Edition (MindTap Course List)
9th Edition
ISBN: 9781305635937
Author: Eugene F. Brigham, Joel F. Houston
Publisher: Cengage Learning
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Textbook Question
Chapter 13, Problem 14SP

WACC 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 firm's debt cost at different debt levels:

Chapter 13, Problem 14SP, WACC AND OPTIMAL CAPITAL STRUCTURE Elliott Athletics is trying to determine its optimal capital

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 40%. Elliott estimates that if it had no debt, its “unlevered” beta, bU, would be 1.2.

  1. a. What is the firm's optimal capital structure, and what would be its WACC at the optimal capital structure?
  2. b. If Elliott's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure?
  3. c. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on Elliott's target capital structure?
  4. 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.
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Diol 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…
If interaction effects make it difficult for a firm to adjust its capital structure based on prevailing conditions, then Group of answer choices the firm should use as much debt financing as possible when it is financially healthy in order to benefit from lower corporate taxes                                                                                                                                                                                                                          the firm should target a 50% debt/50% equity capital structure the firm should choose the capital structure that will minimize all transaction costs--both direct and indirect the firm should use more equity financing than is necessarily optimal today
OPTIMAL CAPITAL STRUCTURE   Jackson Trucking Company is the process of setting its target capital structure. The CFO belives that the optimal debt to capital ratio is somewhere between 20% and 50% and her staff has compiled the following projections for EPS and the stock price at various debt levels: Debt/Capital Ratio Projected EPS Projected Stock Price  20% $3.20 $35.00 30 3.45 36.50 40 3.75 36.25 50 3.50 35.50 Assuming that the firm uses only debt and common equity, what is Jackson's Optimal Capital structure? At what debt-to-capital ratio is the company's WACC Minimized?

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Fundamentals of Financial Management, Concise Edition (MindTap Course List)

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