Second, the pretax operating income is assumed to be
unaffectedbythefirm’sfinancingmixand,byextension,its
bondrating.If theoperating incomechangeswith afirm’s
default risk, the basic analysis will not change, but
minimizingthecostofcapitalmaynotbetheoptimalcourse
ofactionsincethevalueofthefirmisdeterminedbyboththe
cashflowsandthecostofcapital.Thevalueofthefirmwill
havetobecomputedateachdebtlevel,andtheoptimaldebt
ratio will be that which maximizes firm value.
ILLUSTRATION 6.9: Analyzing theCapital Structure for
Titan Cement
Thecostofcapitalapproachcanbeusedtofindtheoptimal
capitalstructureforafirm,aswewillforTitanCementin
2005.Attheendof2004,TitanCementhaddebtoutstanding
of 414 million euros on its book, giving it a market
debt-to-capitalratioof17.60%.TheunleveredbetaforTitan
Cementbasedongloballytradedcementcompaniesin 2005
was0.80.Thefollowingtablesummarizes theestimatesof
betaandcostofequity(assumingarisk-freerateof3.41%
and a risk premium of 4.46%) for different debt ratios:
Debt RatioBetaCost of Equity
0% 0.806.99%
10 0.877.28
20 0.957.65
30 1.068.13
40 1.208.76
50 1.409.65
60 1.7010.99