Union Street Records is considering a new capital structure. The CFO has prepared a list of options:
| Option |
Debt-to-capital ratio |
Bond rating |
Interest rate |
| 1 |
0 |
AA |
0.04 |
| 2 |
0.25 |
BBB |
0.05 |
| 3 |
0.5 |
B |
0.07 |
| 4 |
0.75 |
C |
0.09 |
The company currently has a debt-to-capital ratio of 0.75 (option 4) and an equity beta of 1.9. The tax rate is 34%.
The risk-free rate is 2% and the expected equity market risk premium is 9%.
1. What is the unlevered beta?
2. Find the levered beta for each option. What is the levered beta for option 2 (debt-to-capital ratio of 0.25)?
3. Find the cost of equity for each option. What is the cost of equity for option 2 (debt-to-capital ratio of 0.25)?
4. Find the WACC for each option. What is the WACC for option 3 (debt-to-capital ratio of 0.5)?
5. What is the WACC at the optimal capital structure?