Question

Feldspar Inc. is considering the capital structure for a new division. Management has been given the following cost information:

Debt/assets

.30, .40, .50, .60, .70

Kd

.10, .105, .11, .117, .13

Ke

.125, .13, .135, .142, .155

Based on this information, what capital structure (debt/asset ratio) should management accept? Assume the marginal tax rate is 40%

Answer 1

Option 4

Step-by-step explanation:

In this question ,we have to compute the WACC which is shown below:

= Weightage of debt × cost of debt × ( 1- tax rate) + (Weightage of common stock) × (cost of common stock)

For Option 1, it would be

= (0.3 × 10%) × ( 1 - 40%) + (0.7 × 12.5%)

= 1.8% + 8.75%

= 10.55%

For Option 2, it would be

= (0.4 × 10.5%) × ( 1 - 40%) + (0.6 × 13%)

= 2.52% + 7.8%

= 10.32%

For Option 3, it would be

= (0.5 × 11%) × ( 1 - 40%) + (0.5 × 13.5%)

= 3.3% + 6.75%

= 10.05%

For Option 4, it would be

= (0.6 × 11.7%) × ( 1 - 40%) + (0.4 × 14.2%)

= 4.212% + 5.68%

= 9.89%

For Option 5, it would be

= (0.7 × 13%) × ( 1 - 40%) + (0.3 × 15.5%)

= 5.46% + 4.65%

= 10.11%

So based on this, the management should accept option 4 as it derives the best debt asset ratio

The weightage of equity would be come

= 1 - weightage of debt