Textbook Problem

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:

Elliott uses the CAPM to estimate its cost of common equity, r_s, 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, b_U, 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.