Problem # 1
WACC and optimal capital structure – Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table showing its debt cost at different levels:
Column 1 = Debt-to-Assets Ratio
Column 2 = Equity-to-Assets Ratio
Column 3 = Debt-to-Equity Ratio (D/E)
Column 4 = Bond Rating
Column 5 = Before-tax-Cost of Debt
0.0
To determine the optimal capital structure of Elliott Athletics, we need to consider the Weighted Average Cost of Capital (WACC) at different levels of debt.
The company has provided a table showing different debt-to-assets ratios, equity-to-assets ratios, debt-to-equity ratios, bond ratings, and before-tax cost of debt.
To calculate WACC, we need to calculate the cost of equity and the cost of debt, and then determine the appropriate weights for each component.
1. Cost of Equity:
The cost of equity can be determined using the Capital Asset Pricing Model (CAPM) or other methods such as the Dividend Discount Model (DDM) or the Earnings Capitalization Model (ECM). We will use the CAPM in this example.
The CAPM formula is:
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
You will need the following inputs:
- Risk-free rate: The risk-free rate can be obtained from government bond yields or other risk-free assets.
- Beta: Beta measures the stock's sensitivity to market movements and can be obtained from financial databases or regression analysis.
- Equity Risk Premium: This is the additional return investors demand for investing in equities over the risk-free rate. It can be obtained from historical data or market sources.
2. Cost of Debt:
The cost of debt is the before-tax cost of debt provided in the table. This rate represents the interest rate the company would have to pay on new debt issuances.
3. Weights:
The weights represent the proportion of debt and equity in the company's capital structure. The weights can be calculated using the debt-to-assets and equity-to-assets ratios from the table.
Once you have calculated the cost of equity, cost of debt, and the weights, you can calculate the WACC using the following formula:
WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt)
You can repeat this calculation for each debt level in the table and compare the resulting WACCs. The optimal capital structure is the one that minimizes the WACC, as it indicates the lowest overall cost of capital for the company.