Diol 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. To estimate how much its debt would cost at different debt levels, the company’s treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table: Structure Market Debt-to-Value Ratio (Wd) Market Equity-to-Value Ratio (Ws) Bond Rating Pre-tax Cost of Debt (rd) A 0.0 1.0 AA 9.0% B 0.2 0.8 BBB 10.5% C 0.5 0.5 BB 11.6% D 0.6 0.4 C 12.7% E 0.75 0.25 D 14.0% Diol uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free rate is 7%; the market risk is 13%, and the company’s tax rate is 20%. Diol estimates that if it had no debt, its “unlevered” beta, bU, would be 1.3. What is the levered beta of structure E? (Round final answers to the nearest two decimal places) What is the cost of common equity of structure C? (Answer these percentages in amounts with two decimal points e.g. xx.xx; do not denote percentage anymore) Which of the capital structures is the most optimal? What is the WACC of the optimal capital structure? (Answer these percentages in amounts with two decimal points e.g. xx.xx; do not denote percentage anymore)

Fundamentals Of Financial Management, Concise Edition (mindtap Course List)

10th Edition

ISBN:9781337902571

Author:Eugene F. Brigham, Joel F. Houston

Publisher:Eugene F. Brigham, Joel F. Houston

Chapter13: Capital Structure And Leverage

Section: Chapter Questions

Problem 14SP: WACC AND OPTIMAL CAPITAL STRUCTURE Elliott Athletics is trying to determine its optimal capital...

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Diol 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. To estimate how much its debt would cost at different debt levels, the company’s treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:

Structure	Market Debt-to-Value Ratio (Wd)	Market Equity-to-Value Ratio (Ws)	Bond Rating	Pre-tax Cost of Debt (rd)
A	0.0	1.0	AA	9.0%
B	0.2	0.8	BBB	10.5%
C	0.5	0.5	BB	11.6%
D	0.6	0.4	C	12.7%
E	0.75	0.25	D	14.0%

Diol uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free rate is 7%; the market risk is 13%, and the company’s tax rate is 20%. Diol estimates that if it had no debt, its “unlevered” beta, bU, would be 1.3.

What is the levered beta of structure E? (Round final answers to the nearest two decimal places)
What is the cost of common equity of structure C? (Answer these percentages in amounts with two decimal points e.g. xx.xx; do not denote percentage anymore)
Which of the capital structures is the most optimal?
What is the WACC of the optimal capital structure? (Answer these percentages in amounts with two decimal points e.g. xx.xx; do not denote percentage anymore)

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