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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
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 | 6.0 | % | |||
0.10 | 0.90 | 0.1111 | 6.4 | ||||
0.20 | 0.80 | 0.2500 | 7.0 | ||||
0.30 | 0.70 | 0.4286 | 8.2 | ||||
0.40 | 0.60 | 0.6667 | 10.0 |
F. Pierce uses the
Debt: %
Equity: %
WACC: %
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- Indicate whether each of the following statements is true or false. Support vour answers with relevant explanations.A) Modigliani and Miller's Proposition II assumes that increased borrowin does not afffect the interest rate on the firm's debt.B) Under the conditions of perfect capital markets the cost of capital of a company financed fully by equity is expected to be equal to that of the same company but financed with 50% equity and 50% debt. C) The higher the systematic risk of a company's stock, the higher the value of its beta. The higher the beta, the higher the return required by investors.arrow_forwardWhy is it important to include the tax effect into cost of capital computations for firms with debt financing? Multiple Choice taxable income is reduced by the amount of the interest expense. taxes are paid on interest but not on dividends. firms pay taxes on the outstanding principal amount of the debt. comparisons with equity financing would otherwise not be possible.arrow_forwardPatented Products is considering changing its capital structure. Patented currently has no debt and no preferred stock, but it would like to add some debt to take advantage of the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: Debt ratio (wd) Equity ratio (we) Debt/Equity ratio B-T cost of debt 0.0 1.0 0.0 6.0% 0.10 0.90 0.1111 6.4 0.20 0.80 0.2500 7.0 0.30 0.70 0.4286 8.2 0.40 0.60 0.6667 10.0 Patented uses the CAPM to estimate its cost of common equity, rs, and at the…arrow_forward
- Assume that there is corporate tax, but no other frictions. Based on the propositions of Modigliani and Miller, which statement is the least accurate? Oa. The weighted cost of capital decreases as the leverage ratio increases. D. The cost of debt increases as the leverage ratio increases. C. Firm value increases as the firm takes on more debts. d. The cost of equity increases as the leverage ratio increases. O e. The optimal structure is 100% debt.arrow_forwardB.F. Pierce & Company is considering changing its capital structure. The company currently has no debt and no preferred stock, but it 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: 9.21% 9.07% 8.83% Market Debt-to- Value Ratio 8.66% (WD) 0.00 0.20 0.40 0.60 0.80 Market Equity-to- Value Ratio (WE) 1.00 0.80 0.60 0.40 0.20 Market Debt-to- Equity Ratio (D/E) 0.00 0.25 0.67 1.50 4.00 The company uses the CAPM to estimate its cost of common equity. Currently the risk-free rate is 5%, the market risk premium is 6%, and the company's tax rate is 35%. The company estimates that its beta now (which is unlevered because it currently has no debt) is 0.8. Based on this information, what is the firm's weighted average cost of capital at its optimal capital structure? Before-Tax Cost of Debt (rD) 4.00% 6.00% 8.00% 10.00% 12.00%arrow_forwardHow does the WACC DCF methodology mechanically incorporate interest tax shields (select the best answer)? Group of answer choices By estimating free cash flows that incorporate the tax benefits of debt. By adding the tax benefits of interest payments to the value of the firm. By adding the PV of the interest tax shields to the value of the firm. By estimating a discount rate that incorporates the tax benefits of debt.arrow_forward
- Capital rationing: Select one: O a. assures shareholder wealth maximization. O b. is a way of preserving the assets of the firm over the long term. O c. assures maximum potential profitability. O d. is a less than optimal way to arrive at capital budgeting decisions.arrow_forwardThis question is related to Chapter 18 of Berk & Demarzo "Capital Budgeting and Valuation with Leverage". How do the calculations of the firm value using the APV method differ between the following assumptions? The growth rate of the EBIT and the debt-equity ratio will be constant The growth rate of the EBIT and the interest coverage ratio will be constant. The firm selects the optimal interest coverage ratio and maintains this ratio constant forever (corporate taxes are the only imperfection) Are the values that result different or equal?arrow_forwardCapital Structure Analysis The Rivoli Company has no debt outstanding, and its financial position is given by the following data: Expected EBIT Growth rate in EBIT, gL Cost of equity, rs Shares outstanding, no Tax rate, T (federal-plus-state) a. What is Rivoli's intrinsic value of operations (i.e., its unlevered value)? Round your answer to the nearest dollar. $ What is its intrinsic stock price? Its earnings per share? Round your answers to the nearest cent. Intrinsic stock price: $ $500,000 0% 10% 100,000 What is the new earnings per share? Do not round intermediate calculations. Round your answer to the nearest cent. $ 25% Earnings per share: $ b. Rivoli is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a capital structure with 25% debt based on market values, its cost of equity, rs, will increase to 11% to reflect the increased risk. Bonds can be sold at a cost, rd, of 6%. Based on the new capital structure, what is the new weighted…arrow_forward
- F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of 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 Equity Ratio (D/S) 0.00 0.1111 0.2500 0.4286 0.6667 Market Equity-to- Value Ratio (ws) 1.0 0.90 6.0% 6.4 0.80 7.0 8.2 0.70 0.60 10.0 F. Pierce uses the CAPM to estimate its cost of common equity, rs, and at the time of the analaysis the risk-free rate is 6%, the market risk premium is 8%, and the company's tax rate is 25%. F. Pierce estimates that its beta now (which is "unlevered" because it currently has no debt) is 0.7. Based on this information, what is the firm's optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure? Do not round intermediate calculations. Round your answers to two…arrow_forwardB.F. Pierce & Company is considering changing its capital structure. The company currently has no debt and no preferred stock, but it 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: 8.66% 9.21% 8.83% Market Debt-to- Value Ratio 9.07% (WD) 0.00 0.20 0.40 0.60 0.80 Market Equity-to- Value Ratio (WE) 1.00 0.80 0.60 0.40 0.20 Market Debt-to- Equity Ratio (D/E) 0.00 0.25 0.67 1.50 4.00 Before-Tax Cost of Debt (rD) 5.00% The company uses the CAPM to estimate its cost of common equity. Currently the risk-free rate is 4%, the market risk premium is 6%, and the company's tax rate is 25%. The company estimates that its beta now (which is unlevered because it currently has no debt) is 0.8. Based on this information, what is the firm's weighted average cost of capital at its optimal capital structure? 6.00% 7.00% 8.00% 9.00%arrow_forwardIf interaction effects make it difficult for a firm to adjust its capital structure based on prevailing conditions, then Group of answer choices the firm should use as much debt financing as possible when it is financially healthy in order to benefit from lower corporate taxes the firm should target a 50% debt/50% equity capital structure the firm should choose the capital structure that will minimize all transaction costs--both direct and indirect the firm should use more equity financing than is necessarily optimal todayarrow_forward
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