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Percent financed with debt (wd) Percent financed with equity (wc) 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, 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%.

Percent financed with debt (wd) Percent financed with equity (wc) 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, 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%.

Essentials Of Investments
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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  1. 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 (%)

0.25

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, 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)

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