Determining the optimal capital structure Tandino Inc, currently has no debt in

Question

Determining the optimal capital structure Tandino Inc, currently has no debt in its capital structure, but it is considering raising its debt and reducing its outstanding equity. The firm's unlevered beta is 1.20 and its cost of equity is 11.5%. Since the firm has no debt, its WACC also equals 11.5%. The risk-free rate of interest (r ) is 5%, and the market risk premium (RPH) is also 5%, Tandino's marginal tax rate is 40%. Tandino is examining how different levels of dent will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information shown below to analyze its WACC. Complete the table below.

Explanation / Answer

2. rs = Krf + Beta*MRP So Beta = (rs-Krf)/MRP = (11.9% - 5%)/5% = 1.38 3. WACC = rd*(1-T)*Wd + rs*Ws where rd is cost fo Debt, rs is cost of Equity, Wd is weight of Debt & Ws is weight of Equity ie WACC = 9.8%*(1-40%)*0.4 + 0.6*13.4% = 10.4% 4. WACC = rd*(1-T)*Wd + rs*Ws ie rs = (WACC - rd*(1-T)*Wd)/Ws = (10.6% - 11.2%*(1-40%)*0.6)/0.4 = 16.4% 5. D/E Ratio = Wd/Ws = 0.8/0.2 = 4 WACC = rd*(1-T)*Wd + rs*Ws = 14%*(1-40%)*0.8 + 25.4%*0.2 = 11.8%

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