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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 preferred stock, but 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-Value Ratio (wd) Market Equity-to-Value Ratio (ws) Market Debt-to-Equity Ratio (D/S) Before-Tax Cost of Debt (rd)
0.0 1.0 0.00 7.0%
0.2 0.8 0.25 8.0
0.4 0.6 0.67 10.0
0.6 0.4 1.50 12.0
0.8 0.2 4.00 15.0
F. Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the analysis the risk-free rate is 4%, the market risk premium is 4%, and the company's tax rate is 35%. F. Pierce estimates that its beta now (which is "unlevered" since it currently has no debt) is 1.2. Based on this information, what is the firm's optimal capital structure, and what would the weighted average cost of capital be at the optimal capital structure? Do not round intermediate calculations. Round your answers to two decimal places.
DEBT _________ %
EQUITY __________ %
WACC ___________%
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