Q2. Suppose you are the chief financial officer of Toktik Co. and you are trying to determine the optimal capital structure for the company using the cost of capital approach. On the day of this exam, you have collected the following company and market data: The beta of the company is 2.6; • 10-year Treasury bond rate is 1.6% and the current market equity risk premium is 6.9%; The company's current bond rating is BB by Standard & Poor's; The firm currently has 5.2 billion shares outstanding with share price at $120 and the firm's market value of debt is $264 billion • The company's marginal tax rate is 35%. Also you are given the following table concerning the latest information on bond rating and the corresponding default spread: Rating AAA Default spread 0.69% AA 0.85% A+ 1.07% A 1.18% A- 1.33% BBB 1.71% BB+ 2.31% BB 2.77% B+ 4.05% B В- 4.86% 5.94% ССС 9.46% CC 9.97% 13.09% D 17.44% Required: a) Briefly explain, by referencing relevant capital structure theories, the mechanisms through which one can use the cost of capital approach to estimate the optimal capital structure of a company.
Q2. Suppose you are the chief financial officer of Toktik Co. and you are trying to determine the optimal capital structure for the company using the cost of capital approach. On the day of this exam, you have collected the following company and market data: The beta of the company is 2.6; • 10-year Treasury bond rate is 1.6% and the current market equity risk premium is 6.9%; The company's current bond rating is BB by Standard & Poor's; The firm currently has 5.2 billion shares outstanding with share price at $120 and the firm's market value of debt is $264 billion • The company's marginal tax rate is 35%. Also you are given the following table concerning the latest information on bond rating and the corresponding default spread: Rating AAA Default spread 0.69% AA 0.85% A+ 1.07% A 1.18% A- 1.33% BBB 1.71% BB+ 2.31% BB 2.77% B+ 4.05% B В- 4.86% 5.94% ССС 9.46% CC 9.97% 13.09% D 17.44% Required: a) Briefly explain, by referencing relevant capital structure theories, the mechanisms through which one can use the cost of capital approach to estimate the optimal capital structure of a company.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Concept explainers
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Question
Transcribed Image Text:Q2. Suppose you are the chief financial officer of Toktik Co. and you are trying to
determine the optimal capital structure for the company using the cost of capital
approach. On the day of this exam, you have collected the following company and
market data:
The beta of the company is 2.6;
• 10-year Treasury bond rate is 1.6% and the current market equity risk premium is
6.9%;
• The company's current bond rating is BB by Standard & Poor's;
• The firm currently has 5.2 billion shares outstanding with share price at $120 and
the firm's market value of debt is $264 billion
• The company's marginal tax rate is 35%.
Also you are given the following table concerning the latest information on bond
rating and the corresponding default spread:
Default spread
Rating
AAA
0.69%
AA
0.85%
A+
1.07%
A
1.18%
А-
1.33%
BBB
1.71%
BB+
2.31%
BB
2.77%
B+
4.05%
4.86%
В-
5.94%
ССС
9.46%
CC
9.97%
13.09%
D
17.44%
Required:
a) Briefly explain, by referencing relevant capital structure theories, the mechanisms
through which one can use the cost of capital approach to estimate the optimal capital
structure of a company.
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