Piedmont Instruments Corporation has estimated the following costs of debt and equity capital for various fractions of debt in its capital structure.
Debt Fractions ki ke with financial ke with financial distress w/o agency costs distress with agency costs
0.00 12.00% 12.00%
0.10 4.80% 12.05% 12.05%
0.30 4.90% 12.10% 12.20%
0.40 5.00% 12.20% 12.60%
0.45 5.20% 12.40% 13.40%
0.50 5.70% 12.80% 14.80%
0.60 7.00% 15.00% 18.00%
a. Based on these data, determine the company’s optimal capital structure (i) with financial distress costs and without agency costs and (ii) with financial distress and agency costs.
b. Suppose the company’s actual capital structure is 50 percent debt and 50 percent equity. How much higher is ka at this capital structure than at the optimal value of ka with financial distress and agency costs?
c. Is it necessary in practice for the company to know precisely its optimal capital structure? Why?
Click here for the SOLUTION