Problem 3: WACC and Optimal Capital Structure

Problem 3: WACC and Optimal Capital Structure

This problem is easiest to complete in Excel. Structure consists of only debt and common equity. XYZ’s finance department staff created the following table showing the firm’s debt cost at different debt levels:

Debt-to-Capital RatioEquity-to-Capital RatioDebt-to-Equity RatioBond RatingBefore-Tax Cost of Debt0.01.00.00A6.0%0.20.80.25BBB7.0%0.40.60.67BB9.0%0.60.41.50C11.0%0.80.24.00D14.0%

XYZ uses the CAPM to estimate its cost of common equity and estimates that the risk-free rate is 4 percent, the market risk premium is 7 percent, and its tax rate is 35 percent. XYZ estimates that if it had no debt, its “unlevered” beta would be 1.5.

1. What would be its WACC at the optimal capital structure? What would the firm’s optimal capital structure be?
2. If XYZ’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. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ’s target capital structure?

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