Elliot 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 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
DebtToValue Ratio (Wd)

Market
EquityToValue
Ratio (We)

Market
DebtToEquity
Ratio (D/S)

Bond
Rating

BeforeTax
Cost of Debt (rd)

0.0

1.0

0.00

A

7.0%

0.2

0.8

0.25

BBB

8.0%

0.4

0.6

0.67

BBB

10.0%

0.6

0.4

1.50

C

12.0%

0.8

0.2

4.00

D

15.0%

Elliot uses the CAPM to estimate its cost of the common
eqity, r_{s. }The company
estimates that the riskfree rate is 5%, the market risk premium is 6%, and its
tax rate is 40%. Elliot estimates that if it had no debt, its unlevered beta,
bu, would be 1.2. Based on the information, what is the firm’s optimal capital
structure, and what would the WACC be at the optimal capital structure?
