Problem 21-05 Given the following, determine the firm’s optimal capital structure: Debt/Assets After-Tax Cost of Debt Cost of Equity 0 % 7 % 11 % 10 7 11 20 7 11 30 8 12 40 9 14 50 10 15 60 13 16...

Problem 21-05

1. Given the following, determine the firm’s optimal capital structure:
   

   
   

   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   
   

   Debt/Assets	After-Tax Cost of Debt	Cost of Equity
   0	%	7	%	11	%
   10		7		11
   20		7		11
   30		8		12
   40		9		14
   50		10		15
   60		13		16

   
   

   
   

   Round your answers for capital structure to the nearest whole number and for the cost of capital to one decimal place.

   
   

   The optimal capital structure:   % debt and   % equity with a cost of capital of   %

   
   


2. If the firm were using 20 percent debt and 80 percent equity, what would that tell you about the firm’s use of financial leverage? Round your answer for the cost of capital to one decimal place.
   

   If the firm uses 20% debt financing, it would be using  financial leverage. At that combination the cost of capital is   %. The firm could lower the cost of capital by substituting  .

   
   


3. What two reasons explain why debt is cheaper than equity?
   

   Debt is cheaper than equity because interest expense  . In addition, equity investors bear  risk.

   
   


4. If the firm were using 20 percent debt and 80 percent equity and earned a return of 9.0 percent on an investment, would this mean that stockholders would receive less than their required return of 11.0 percent?
   

   If the firm earns 9.0% on an investment, the stockholders will earn  than their required 11.0%.

   
   

   What return would stockholders receive? Round your answer to one decimal place.

   
   

     %