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Maintain a debt to equity ratio

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Reference no: EM131987235

The following assumptions are used to determine the cost of capital. 

Historically, the company tried to maintain a debt to equity ratio equal to 0.40. This ratio was used, because lowering the debt implies giving up the debt tax shield, and increasing it makes debt service a burden on the firm's cash flow. In addition, increasing the debt level may cause a reduced rating of the company's bonds. The marginal tax rate is 35%.

Cost of debt:

The company's bond rating is roughly AAA. Surveying the debt market yielded the following information about the cost of debt for different rating levels:

The company's current bonds have a yield to maturity of about 4.25%.

Cost of equity:

The current 10-year Treasury notes have a yield to maturity of 2.25% and the forecast for the S&P 500 market premium is 7.5%.  The company's overall b is 1.25.

Reference no: EM131987235

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