The cost of both depth equity and capital rise as a firm increases its reliance

Question

The cost of both depth equity and capital rise as a firm increases its reliance on one or the other. Suppose that a for-profit company has idenitifed the following costs for debt and equity:

Percent Debt     After Tax Cost of Debt    Cost of Equity

0                           ----                                     12%

25                          5.5%                                 14%

50                          7.5%                                  16%

75                         8.5%                                     19%

What is the optimal capital structure for this firm?

Explanation / Answer

Optimal capital structure for this firm is the capital structure where WACC is lower in all capital structure .

Therefore Optimal capital structure for this firm is 75% Debt and 25% Equity

Percent Debt      After Tax Cost of Debt     Cost of Equity WACC [a] [b] [c] [d = a*b + (1-a)*c] 0% 0% 12% 12.00% 25% 5.50% 14% 11.88% 50% 7.50% 16% 11.75% 75% 8.50% 19% 11.13% Optimal

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