Angel Athletics is trying to determine its optimal capital structure. 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:
Percent financed Percent financed Debt-to-equity Bond Before-tax
With debt (wd) with equity (wE) ratio (D/E) rating Credit Spread
0.10 0.90 0.10/0.90 = 0.11 AAA 0.7%
0.20 0.80 0.20/0.80 = 0.25 AA 1.0%
0.30 0.70 0.30/0.70 = 0.43 A 1.4%
0.40 0.60 0.40/0.60 = 0.67 BBB 2.2%
0.50 0.50 0.50/0.50 = 1.00 BB+ 3.4%
0.70 0.30 0.70/0.30 = 2.33 BB- 6.6%
0.90 0.20 0.90/0.10 = 9.00 B 10.8%
The company's tax rate, τ, is 50 percent. The company uses the CAPM to estimate its cost of common equity, re. The risk-free rate is 4% and the market risk premium is 6%. Angel estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," βU, equals 1.0.) The levered beta, β, relates to the unlevered beta, βU, via β = [1 + (1 - τ)*D/E] βU.
A. On the basis of this information, whereby WACC is minimized?
B. If the tax rate is reduced to 10.1%, whereby WACC is minimized?
Based on your findings, then, argue what are the macro consequences of a reduction of corporate tax rate from 50.01% to 10.01%?