04 Jun Question F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but would like to add some debt t
Question
F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but would like to add some debt to take advantage of low interest rates and the tax shield. Its investment banker has indicated that the pretax rate cost of debt under various possible capital structures would be as follows:
Market Debt to Value Ratio (wd)
Market Equity to Value Ratio (wS)
Market Debt to Equity Ratio (D/S)
Before tax cost of debt (rd)
0.0
1.0
0.00
6.0%
.2
.8
.25
7.0%
.4
.6
.67
8.0%
.6
.4
1.50
9.0%
.8
.2
4.00
10.0%
F. Pierce uses the CAPM to estimate its cost of common equity, rs, and at the time of the analysis, the risk free rate is 5%, the market risk premium is 6%, and the company’s tax rate is 40%. F. Pierce estimates that its beta now (which is “unlevered” because it curren
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