Question

The weighted average cost of capital: 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 80​% debt. American Exploration currently has 5​% ​after-tax cost of debt and a 10​% 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 80​%? 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 14​%. 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

Solution: - American Exploration Ine. @ What is American Exploration's Current WAC? Weight of Debt in capital structure - 500%. Weight of Equity in capital structure = 509. After Tax cost of Debt = 54. Or 0.05 lost of Equity = 10%. or 0.10 Weighted Average cost of capital (WACC) = . ( Weight of Debtx After Tax cost of Debt) + (weight of Equity x cost of Equity) = ( 50%. 0.05) + (504x0.1) a 0.015 + 0.05 - 0.075 07 7.5%. So, the cussent wAcc is 7.5% (6) 4 the capital structure is changed with 80''dest and 20% equity , then wAcc will bey ( Weight of Debtx After Tax cost of Debt) + (weight of Equity x cost of Equity)

= ( 804% 0.05) + ( 80% X0.1) El pe X 0.05) + (doa X 0.1) 2 0.04 + 0.08 = 0.06 or 6% This WACC is computed with the assumption th cost of debt and equity remains unchanged. (C) Ves, the shareholders are affected by the increase in debt to 804, because their common stock claims are riskier now because langer interest expenses must be paid prior to any dividend payment Interest payment is done from the earning before interest and taxes, and after then taxes are paid then dividends are distributed So, when interest expenses will be higher due to largere debt in capital structure, the shareholder will be affected,

(d) Suppose cost of new WALL :- equity increases to 14%, then (Weight of Debty After tax cost of Debt) + ( Weight of Equity x I - cost of Equity) = ( 80% X 0.05) + ( 20% * 0.14) = ( COX 0.05) + ( a.co * 0.14) = 0.04 + 0.098 0.068 08 6.8.1. - le) According to the answer in part (d), it is suggested that Increasing the debt in the capital structure can increase the risk of the company of not being able to make its interest payment and it will also lead to shareholder increasing their sequised rate of return that will increase the cost of equity. As the common stock claims are riskier with increase in debt, so shareholder also increase their required rate of return to neutralize the effect of zisk.