The finance director of Benga Ltd. wishes to find the company's optimal capital structure. The cost of debt varies according to the level of gearing of the company as follows:
|
Percentage debt
|
Pretax cost of debt
|
|
10
20
30
40
50
60
70
|
6.5%
7.1%
7.8%
8.5%
10%
12%
15%
|
The company's ungeared equity beta (asset beta) is 0.85. The risk free rate is 6% per annum and the market return is 14% per annum. Corporate taxation is at the rate of 30% per year.
Required:
(a) Estimate the company's optimal weighted average cost of capital.
(b) Recommend whether or not the company should adopt the optimal capital structure identified in (a) above explain the factors that might influence the capital structure decision.