Question

American​ Exploration, Inc., a natural gas​ producer, is trying to decide whether to revise its target capital structure. Currently it targets a 50​-50 mix of debt and​ equity, but it is considering a target capital structure with 70​% debt. American Exploration currently has 6​% ​after-tax cost of debt and a 12​% cost of common stock. The company does not have any preferred stock outstanding.
a. What is American​ Exploration's current​ WACC?
b. Assuming that its cost of debt and equity remain​ unchanged, what will be American​ Exploration's WACC under the revised target capital​ structure?
c. Do you think shareholders are affected by the increase in debt to 70​%? If​ so, how are they​ affected? Are the common stock claims riskier​ now?
d. Suppose that in response to the increase in​ debt, American​ Exploration's shareholders increase their required return so that cost of common equity is 16​%. What will its new WACC be in this​ case?
e. What does your answer in part d suggest about the tradeoff between financing with debt versus​ equity?

Answer 1

Answer:

a) 9.00 %

b) 7.80 %

c) yes the weight of the debt increases here is more risk in the investment as the debt payment are mandatory and failing to do so result in bankruptcy while the stock can wait to receive dividends if the income statement are good enough

d) 9.00  %

e) The increase in debt may lñead to an increase in return of the stockholders if they consider the stock riskier than before and will raise their return until the WACC equalize at the initial point beforethe trade-off occurs

Explanation:

a)

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke 0.12

Equity weight 0.5

Kd(1-t) = after tax cost of debt = 0.06

Debt Weight = 0.5

$WACC = 0.12(0.5) + 0.06(0.5)$

WACC 9.00000%

c)

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke 0.12

Equity weight 0.3

Kd(1-t) = after tax cost of debt = 0.06

Debt Weight 0.7

$WACC = 0.12(0.3) + 0.06(0.7)$

WACC 7.80000%

d)

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke 0.16

Equity weight 0.3

Kd(1-t) = after tax cost of debt = 0.06

Debt Weight 0.7

$WACC = 0.16(0.3) + 0.06(0.7)$

WACC 9.00000%