3. If Congress were to dramatically increase the corporate tax rate, what effect
ID: 2637867 • Letter: 3
Question
3. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ's target capital structure?
Can you please tell me if my calculations are correct?
This problem is easiest to complete in Excel. Structure consists of only debt and common equity. XYZ's finance department staff created the following table showing the firm's debt cost at different debt levels: Tax rate 35% Risk free rate (rRF) 4% Risk premium (rM) 7% unlevered beta (bu) 1.5 Debt-to-Capital Ratio Equity-to-Capital Ratio Debt-to-Equity Ratio Bond Rating Before-Tax Cost of Debt Beta Cost of Equity WACC (wd) (we) (D/E) (rd) ((rd(1-T)) (b) rs 0.0 1.0 0.00 A 6.0% 1.50 8.50% 8.50% 0.2 0.8 0.25 BBB 7.0% 1.53 8.58% 8.26% 0.4 0.6 0.67 BBB 9.0% 1.59 8.77% 8.86% 0.6 0.4 1.50 C 11.0% 1.75 9.24% 10.30% 0.8 0.2 4.00 D 14.0% 2.34 11.02% 13.40% XYZ uses the CAPM to estimate its cost of common equity and estimates that the risk-free rate is 4 percent, the market risk premium is 7 percent, and its tax rate is 35 percent. XYZ estimates that if it had no debt, its "unlevered" beta would be 1.5. 1. What would be its WACC at the optimal capital structure? What would the firm's optimal capital structure be? 2. If XYZ's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure?3. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ's target capital structure?
Can you please tell me if my calculations are correct?
Explanation / Answer
1. What would be its WACC at the optimal capital structure? What would the firm's optimal capital structure be?
Optimal capital structure is that capital structure which maximizes the value of the firm and it has to be achieved at lowest WACC which is 8.26%.
it is achieved through 20% debt and 80% equity capital.
2. If XYZ's managers anticipate that the company's business risk will increase in the future, what effect would this likely have on the firm's target capital structure?
Business risk is a non systematic risk which is specific to business. If this risk increases then cost of capital will also increase as chances of financial risk to be incresed is theere. they should decrese the debt part and increase the equity part in their capital structure.
3. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ's target capital structure?
if corporate tax rate increases then tax shield to the company will also increase. it means thet they should increase the debt part so that less income will be available for taxation calculations.
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