LeCompte Learning Solutions Is Considering Making a Change to Its

question 12

Multiple Choice

LeCompte Learning Solutions is considering making a change to its capital structure in hopes of increasing its value.The company's capital structure consists of debt and common stock.In order to estimate the cost of debt, the company has produced the following table: $$\begin{array} { c c c c c } \begin{array} { c } \text { Percent financed } \\\text { with debt } \left( \mathrm { wd } _ { \mathrm { d } } \right) \end{array} & \begin{array} { c } \text { Percent financed } \\\text { with equity } \left( \mathrm { w } _ { \mathrm { S } } \right) \end{array} & \begin{array} { c } \text { Debt-to-equity } \\\text { ratio } = \mathrm { w } _ { \mathrm { d } } / \mathrm { w } _ { \mathrm { S } } = ( \mathrm { D } / \mathrm { S } ) \end{array} & \begin{array} { c } \text { B ond } \\\text { Rating }\end{array} & \begin{array} { c } \text { Before-tax } \\\text { cost of debt }\end{array} \\\hline 0.10 & 0.90 & 0.10 / 0.90 = 0.11 & \text { AAA } & 7.0 \% \\0.20 & 0.80 & 0.20 / 0.80 = 0.25 & \text { AA } & 7.2 \\0.30 & 0.70 & 0.30 / 0.70 = 0.43 & \mathrm {~A} & 8.0 \\0.40 & 0.60 & 0.40 / 0.60 = 0.67 & \mathrm { BBB } & 8.8 \\0.50 & 0.50 & 0.50 / 0.50 = 1.00 & \mathrm { BB } & 9.6\end{array}$$ The company uses the CAPM to estimate its cost of common equity, r_s.The risk-free rate is 5% and the market risk premium is 6%.LeCompte estimates that if it had no debt its beta would be 1.0.(Its "unlevered beta," b_U, equals 1.0.) The company's tax rate, T, is 25%. On the basis of this information, what is LeCompte's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

• A) w_s = 0.9; w_d = 0.1; WACC = 11.73%
• B) w_s = 0.8; w_d = 0.2; WACC = 10.78%
• C) w_s = 0.7; w_d = 0.3; WACC = 9.11%
• D) w_s = 0.6; w_d = 0.4; WACC = 9.50%
• E) w_s = 0.5; w_d = 0.5; WACC = 11.37%

---

Definitions:

Demand

The quantity of a product or service that consumers are willing and able to purchase at various prices over a given period of time.

Positively Sloped

A descriptive term used for a line or curve on a graph that moves upward to the right, indicating a direct relationship between two variables.

Total Surplus

The sum of consumer surplus and producer surplus, reflecting the total net benefit to society from the production and consumption of a good or service.

Equilibrium

A condition where the supply and demand in the market are equal, leading to stable prices.