The Gator Corporation is financed by 50% debt, and 50% equity. Their debt was an

Question

The Gator Corporation is financed by 50% debt, and 50% equity. Their debt was an 8.5% annual interest rate. Their published Beta Coefficient is 1.57. The Risk Free Rate on U.S. Treasasry Securities is 5% and the return on the market portfolio is 10%. Gator is not sure that they have the optimum mix of debt and equality. They are considering the following debt/equity capital structures. Compute Gator's present weighted average cost of capital. Compute the weighted average cost of capital for each potential structure. Assume a 40% corporative tax rate. Should Gator change their capital structure? If so, to which of the following structures? Why? (You must show all your work). 40% debt with an 8% coupon rate, and 60% equity. 60% debt with a 9% coupon rate, and 40% equity. 80% debt with a 10% coupon rate, and 20% equity.

Explanation / Answer

According to the Capital asset pricing model , the required return on equity is calculated as follows :

Re = Rf + Beta [ Rm - Rf ]

Re = 0.05 + 1.57 [ 0.10 - 0.05 ]

Re = 12.85 %

Weighted average cost of capital = We re + Wp rp + Wd rd ( 1 - tc )

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a) WACC = 0.60 X 0.1285 + 0 + 0.40 X 0.08 X ( 1 - 0.40)

WACC = 9.63 %

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b) WACC = 0.40 X 0.1285 + 0 + 0.60 X 0.09 X ( 1 - 0.40)

WACC = 8.38%

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C) WACC = 0.20 X 0.1285 + 0 + 0.80 X 0.10 X ( 1 - 0.40)

WACC = 7.37 %

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