QUESTION 18 Black Keys Manufacturing is considering making a change to its capit
ID: 2710220 • Letter: Q
Question
QUESTION 18
Black Keys Manufacturing 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:
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%. Black Keys estimates that if it had no debt its beta would be 1.1. (Its "unlevered beta," bU, equals 1.1.) The company's tax rate, T, is 40%.
On the basis of this information, what is Black Keys' optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?
we = 0.9; wd = 0.1; WACC = 11.01%
we = 0.8; wd = 0.2; WACC = 10.96%
we = 0.7; wd = 0.3; WACC = 10.75%
we = 0.6; wd = 0.4; WACC = 10.15%
we = 0.5; wd = 0.5; WACC = 10.18%
Percent financed Percent financed Bond Before-tax Levered Cost of equity with debt (wd) with equity (we) Rating cost of debt Beta re WACC 0.1 0.9 AAA 7.00% 0.2 0.8 AA 7.20% 0.3 0.7 A 8% 0.4 0.6 BBB 9.60% 0.5 0.5 BB 10.75%Explanation / Answer
Answer: we=0.6; wd=0.4; WACC=10.15
At wd=0.4 and we = 0.6 WACC is minimum i.e. 10.15% So optimum structure (D/E) is 40/60 = 2/3