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Chapter 15. Ch 15-13 Build a Model

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. To estimate how much its debt would cost at different debt levels, the
company's Treasury staff has consulted with investment bankers and, on the basis of those discussions, has
created the following table:

Market Market Market

Debt/Value Equity/Value Debt/Equity Debt B-T Cost of
Ratio (wd) Ratio (wce) Ratio (D/S) Rating Debt (rd)
0 1 0.00 A 7.00%
0.2 0.8 0.25 BBB 8.00%
0.4 0.6 0.67 BB 10.00%
0.6 0.4 1.50 C 12.00%
0.8 0.2 4.00 D 15.00%

Elliott uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free
rate is 5 percent, the market risk premium is 6 percent, and its tax rate is 40 percent. Elliott estimates that
if it had no debt, its "unlevered" beta, bU, would be 1.2.

a. Based on this information, what is the firm's optimal capital structure, and what would the weighted
average cost of capital be at the optimal structure?

Solution to Part a:

Inputs provided in the problem:

Risk-free rate 5%
Market risk premium 6%
Unlevered beta 1.2
Tax rate 40%

Next, we construct a table (like that in the model) that evaluates WACC at different levels of debt.

The beta is found using the Hamada equation:

b = bU [1+ (1-T)(D/S)]

In Excel format, here is the equation for bL with 10% debt:

Then, with bL, we can apply the CAPM equation to find rs, the cost of equity, and then we can find
the WACC.

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A-T rd = rd(1-T)
rs = rRF + b(rM-rRF)
WACC = wd(rd)(1-T) + wce(rs).

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Debt/Value Equity/Value Debt/Equity A-T Cost of Levered Cost of wd at min
Ratio (wd) Ratio (wce) Ratio (D/S) Debt (rd) Beta Equity WACC WACC
0.0 1.0 0.00
0.2 0.8 0.25
0.4 0.6 0.67
0.6 0.4 1.50
0.8 0.2 4.00

From the table, we see that the optimal capital structure consists of 40% debt and 60% equity.
Using Excel's Minimum function, we find the Min WACC to be:
Using MAX, find the D/A ratio that minimizes the WACC:

b. Plot a graph of the A-T cost of debt, the cost of equity, and the WACC versus the Debt/Value ratio.

Capital costs versus D/V Ratio.

c. Would the optimal capital structure change if the unlevered beta changed? To answer this question, do
a sensitivity analysis of WACC on bU for different levels of bU.

Set up a data table where you find WACC at different values of bU. Then create graphs of WACC vs.
bu and Optimal Cap. Str. Vs bu.
WACC at
Optimal Optimal
Note: to create this data table, select
Unlevered Cap. Str. D/A Ratio cells B97:D102. The select Data,
Beta Table, and enter cell C35 for
"Column input cell".

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The first graph shows that WACC rises if the firm's unlevered beta rises. A higher bU means more
business risk, and risk raises the cost of capital.

The second graph shows the optimal capital structure rising with b U. This occurs because (1) the cost of
equity rises with bU, (2) in our example rd does not rise with bU, hence (3) higher bU's penalize equity,
hence (4) using more debt is especially advantageous at high bU values.

This result occurs because of the way we set up the problem. Realistically, a higher b U would lead to a
higher rd at all levels of bU. That would alter the relationship, possibly resulting in no relationship
between bU and the optimal capital structure.

The point of this part of the problem is to demonstrate that the inputs determine the outputs.

Note that MM assumed that firms could borrow at the riskless rate, regardless of how much debt they
used, and regardless of bU. However, they assumed that the cost of equity varied both with bU and the
amount of debt used. Others have modified the MM assumptions, but our problem demonstrates that
unless the input data are known for sure, which is never the case, we cannot determine the optimal capital
structure for sure. We can find one, but it might be wrong.

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