Jersey Computer Company has estimated the costs of debt and equity capital (with

bankruptcy and agency costs) for various proportions of debt in its capital structure:
Proportion of Debt After-tax Cost of Debt, ki Cost of Equity, ke 0.00 0.10 0.20 0.30 0.40
0.50 0.60 — 4.7% 4.9 5.1 5.5 6.1 7.5 12.0% 12.1 12.5 13.0 13.9 15.0 17.0 a. Determine
the fi rm’s optimal capital structure, assuming a marginal income tax rate (T) of 40
percent. b. Suppose that the fi rm’s current capital structure consists of 30 percent debt
(and 70 percent equity). How much higher is its weighted cost of capital than at the
optimal capital structure?

4. a.

Proportion of Debt Cost of Capital

0.00 ka = 12.0%

0.10 ka = (0.10)(4.7%) + 0.90(12.1%) = 11.36%

0.20 ka = (0.20)(4.9%) + (0.80)(12.5%) = 10.98%

0.30 ka = (0.30)(5.1%) + (0.70)(13.0%) = 10.63%

0.40 ka = (0.40)(5.5%) + (0.60)(13.9%) = 10.54%

0.50 ka = (0.50)(6.1%) + (0.50)(15.0%) = 10.55%

0.60 ka = (0.60)(7.5%) + (0.40)(17.0%) = 11.30%

Therefore, the optimal capital structure is approximately 40% debt and 60% equity.

b. 30% debt and 70% equity: ka = 10.63%

Optimal: ka = 10.54%

Difference: 0.09%