A company is trying to decide on its capital structure.  It estimates the associated after-tax costs of debt and costs of equity at various debt and equity levels to be as shown in the table below.  


a.  Calculate the cost of capital for each level of debt and equity indicated.


b.  Assuming the company chooses a capital structure which minimizes its cost of capital, based on your values calculated, what percentage of debt and equity whould it use?  What is the associated cost of capital?


c.  When a firm initially substitutes debt in place of equity , what typically happens to the cost of capital?  Why?


d.  As more debt gets used why do both the cost of debt and cost of equity rise?

% Debt / Assets After-Tax Cost of Debt % Equity / Assets Cost of Equity Cost of Capital
0% 7.5% 100% 12.0% ?
20% 7.8% 80% 12.3% ?
40% 8.1% 60% 12.8% ?
60% 10.2% 40% 14.0% ?
80% 16.3% 20% 22.0% ?
100% 22.0% 0% 35.0% ?

a.  A company financed with all equity has an expected Free Cash Flow to the Firm (FCFF) of $10 million next year.  Assuming the unlevered cost of equity is 15% and the FCFF is expected to grow at 2% in perpetuity, use the APV method to calculate the value of the firm.


b.  The company now is considering changing its financing sources such that $75 million will come from debt.  Given the following additional information use the APV method to calculate the value of the firm.  (Additional information:  the firm’s marginal tax rate is 40%; the probability of bankruptcy is 20%; the bankruptcy costs are e

Explain why a firm’s capital structure can: 
a.  change over the life of the firm, and

b.  vary from industry to industry.

stimated to be $50 million dollars)


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