LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value. 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 Percent financed Debt-to-equity Bond Before-tax
with debt (wd) with equity (ws) ratio (D/S) Rating cost of debt
0.10 0.90 0.10/0.90 = 0.11 AAA 7.0%
0.20 0.80 0.20/0.80 = 0.25 AA 7.2
0.30 0.70 0.30/0.70 = 0.43 A 8.0
0.40 0.60 0.40/0.60 = 0.67 BBB 8.8
0.50 0.50 0.50/0.50 = 1.00 BB 9.6
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%. LeCompte estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.) The company's tax rate, T, is 40%. On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure? (the lowest WACC)
LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value. 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 Percent financed Debt-to-equity Bond Before-tax
with debt (wd) with equity (ws) ratio (D/S) Rating cost of debt
0.10 0.90 0.10/0.90 = 0.11 AAA 7.0%
0.20 0.80 0.20/0.80 = 0.25 AA 7.2
0.30 0.70 0.30/0.70 = 0.43 A 8.0
0.40 0.60 0.40/0.60 = 0.67 BBB 8.8
0.50 0.50 0.50/0.50 = 1.00 BB 9.6
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%. LeCompte estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.) The company's tax rate, T, is 40%. On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure? (the lowest WACC)
Related questions
GOAL is trying to determine its optimal capital structure. The Companyâs capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
| D/V | Rating | Cost of Debt |
| 0.1 | AA | 7.00% |
| 0.2 | A | 7.2 |
| 0.3 | A | 8 |
| 0.4 | BB | 8.8 |
| 0.5 | B | 9.6 |
The companyâs tax rate is 40 percent. The company uses the CAPM model to estimate its cost of equity. The risk-free rate is estimated to be 5 percent and the equity market risk premium is 6 percent. Companyâs estimate of its asset beta is 1.05
Companyâs operating profit (EBIT) is expected to be $2,000,000 in the foreseeable future. Assume no net investment in fixed assets (only depreciated assets are replenished) and working capital. ABC currently has 1,000,000 outstanding shares.
1) Assume that company is planning to recapitalize to reach an optimal capital structure. Assuming that company will use the new debt to repurchase its shares, for each D/V level determine
a) Market Value of Firm
b) Cost of equity
c) Share Price after the recapitalization announcement
d) Number of shares outstanding following the stock repurchase
e) Market Value of Equity
f) WACC and Optimal Capital Structure
g) At what level of debt, companyâs WACC is minimized? Explain.
2) Reflect on what you have learned about firmâs choice of capital structure in the light of the question above. What other considerations are given in determining capital structure in practice that is not captured in the context of the current question?
ABC is trying to determine its optimal capital structure. The Companyâs capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
| D/V | Rating | Cost of Debt |
| 0.1 | AA | 7.00% |
| 0.2 | A | 7.2 |
| 0.3 | A | 8 |
| 0.4 | BB | 8.8 |
| 0.5 | B | 9.6 |
The companyâs tax rate is 40 percent. The company uses the CAPM model to estimate its cost of equity. The risk-free rate is estimated to be 5 percent and the equity market risk premium is 6 percent. Companyâs estimate of its asset beta is 1.05
Companyâs operating profit (EBIT) is expected to be $2,000,000 in the foreseeable future. Assume no net investment in fixed assets (only depreciated assets are replenished) and working capital. ABC currently has 1,000,000 outstanding shares.
1) On the basis of this information, what are the unlevered companyâs market value and its share price?
2) Assume that company is planning to recapitalize to reach an optimal capital structure. Assuming that company will use the new debt to repurchase its shares, for each D/V level determine
a) Market Value of Firm
b) Cost of equity
c) Share Price after the recapitalization announcement
d) Number of shares outstanding following the stock repurchase
e) Market Value of Equity
f) WACC and Optimal Capital Structure
g) At what level of debt, companyâs WACC is minimized? Explain.
3) Reflect on what you have learned about firmâs choice of capital structure in the light of the question above. What other considerations are given in determining capital structure in practice that is not captured in the context of the current question?
