Stark-Arms Co.'s common stocks and long-term bonds are publicly traded. SA's 2 million shares outstanding of common stocks currently trade for $28 per share. SA's long-term debt has a market value of $30 million, a coupon rate of 8% (coupon payments are made semi-annually), and will mature in 11 years. SA's long-term bonds were last traded for $880. SA has $15 million of total current liabilities. SA pays corporate tax of 30%.
(a) Currently, risk-free rate is 6%, and market portfolio return is 13.75%. Using the data on past monthly returns on SA common shares from the last 2 years, you estimate a maker beta of 1.1. Use CAPM to estimate required return on SA'a equity. Estimate Stark-Arms' WACC. Using a graph show how WACC varies with leverage given the formula you use to compute WACC. Identify the current status of SA on the graph.
(b) Why is it not wise for Stark-Armors to select fully equity- or fully debt-financed financial structures? Is there an \optimal" leverage level for each rm depending on the interaction between tax credit benefits, agency costs, expected costs of financial distress? You believe that Stark-Arms' optimal debt level is 65%. Use a graph that shows the individual and aggregated e ects of the three mentioned factors to compare the optimal debt level with SA's existing level of debt. In three lines explain how revision of Stark-Arms' nancial structure may improve rm value.