U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. I
ID: 2727064 • Letter: U
Question
U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 6%, and its tax rate is 40%. It currently has a levered beta of 1.25. The risk-free rate is 3.5%, and the risk premium on the market is 7%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 8%. Use the Hamada equation to unlever and relever the beta for the new level of debt. What will the firm's weighted average cost of capital (WACC) be if it makes this change in its capital structure? The optimal capital structure is the one that the WACC and the firm's stock price. Higher debt levels the firm's risk. Consequently, higher levels of debt cause the firm's cost of equity to Axis Chemical Co. has found that its expected EPS is maximized at a debt ratio of 45%. Does this mean that Axis Chemical Co.'s optimal capital structure calls for 45% debt? No YesExplanation / Answer
Details Current Ddebt level D=0.30 Current E =0.70 Current levered beta -bUL=1.25 Assume unlevered beta=bUL beta of debt =bD=0, Tax rate T=40% Now , bUL=bD*[D(1-T)]/[D(1-T)+E] +bL*E/[D(1-T)+E] bUL=1.25*0.70/(0.3*0.6+0.7) bUL=0.994 So Unlevered beta=0.994 Required capital structure: D=0.60 E=0.40 T=40% Relevering Beta : bL=bUL+bUL*(1-T)*D/E=0.994+0.994*0.6*0.6/(0.40) bL=1.889 So levered beta at this capiatl structure = 1.889 Risk free rate =3.5% Market risk premium=7% So Cost of equity=3.5%+7%*1.889 = 16.72% Cost of Debt =8% Post tax cost of debt=8%*(1-40%)= 4.80% WACC =16.72%*0.40+4.8%*0.60= 9.57% So WACC =9.57% The optimal capital structure is that ---Minimizes ----the WACC and ---Maximizes--- the firm's stock price. Higher debt levels --increases -- the firm's risk. Consequently higher debt levels cause the firm's cost of equity to ---increase --. As Axis chemical has maximum EPS at debt eatio 45%, its optimal capital structure is at 45% debt level. So the statement is true.
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