Ilumina Corp is trying to determine its optimal capital structure. The company’s capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table: Percent financed with debt (wd)Percent financed with equity (wc)Debt-to-equity ratio (D/S)After-tax cost of debt (%)0.250.750.25/0.75 = 0.336.9%0.350.650.35/0.65 = 0.53857.1%0.500.500.50/0.50 = 1.008.0% The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate is 5% and the market risk premium is 6%. Ilumina estimates that its beta with 10% debt is 1. The company’s tax rate, T, is 40%. On the basis of this information, what is the company’s optimal capital structure, and what is the firm’s cost of capital at this optimal capital structure? (Please show work)

Cost of capital:The cost of capital refers to the amount of money that a company must pay to finance…

Answered: Percent financed with debt (wd)…

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter13: Capital Structure Concepts

Section: Chapter Questions

Problem 4P

See similar textbooks

Related questions

Question

Ilumina Corp is trying to determine its optimal capital structure. The company’s capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:

Percent financed with debt (w_d)	Percent financed with equity (w_c)	Debt-to-equity ratio (D/S)	After-tax cost of debt (%)
0.25	0.75	0.25/0.75 = 0.33	6.9%
0.35	0.65	0.35/0.65 = 0.5385	7.1%
0.50	0.50	0.50/0.50 = 1.00	8.0%

The company uses the CAPM to estimate its cost of common equity, r_s. The risk-free rate is 5% and the market risk premium is 6%. Ilumina estimates that its beta with 10% debt is 1. The company’s tax rate, T, is 40%. On the basis of this information, what is the company’s optimal capital structure, and what is the firm’s cost of capital at this optimal capital structure? (Please show work)

Expert Solution