Aaron Athletics is trying to determine its optimal capital structure. The compan
ID: 2705296 • Letter: A
Question
Aaron Athletics is trying to determine its optimal capital structure. The company%u2019s 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 with debt (Wd)
Percent financed with equity (Ws)
Debt to Equity (D/S)
Bond Rating
Before-tax cost of debt (BT Rd)
10%
90%
.11
AA
4.0%
20%
80%
.25
A
5.0%
40%
60%
.67
BB
6.0%
50%
50%
1.0
B
7.0%
The company%u2019s tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, Rs. The risk-free rate is 1 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (i.e., its %u201Cunlevered beta,%u201D bU, equals 1.0.)
On the basis of this information, what is the company%u2019s optimal capital structure, and what is the firm%u2019s cost of capital at this optimal capital structure? show work please
Percent financed with debt (Wd)
Percent financed with equity (Ws)
Debt to Equity (D/S)
Bond Rating
Before-tax cost of debt (BT Rd)
10%
90%
.11
AA
4.0%
20%
80%
.25
A
5.0%
40%
60%
.67
BB
6.0%
50%
50%
1.0
B
7.0%
Explanation / Answer
rRF = 5%; rM - rRF = 6%.
rs = rRF + (rM - rRF)b
WACC = rd
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