Question

Wilson Corporation (not real) has a targeted capital structure of 40% long term debt and 60% common stock. The debt is yielding 6% and the corporate tax rate is 35%. The common stock is trading at $50 per share and next year's dividend is $2.50 per share that is growing by 4% per year. Prepare a minimum 700-word analysis including the following: Calculate the company's weighted average cost of capital. Use the dividend discount model. Show calculations in Microsoft® Word. The company's CEO has stated if the company increases the amount of long term debt so the capital structure will be 60% debt and 40% equity, this will lower its WACC. Explain and defend why you agree or disagree. Report how would you advise the CEO

Answer 1

Long-Term Debt = 0.4 and Common Stock = 0.6

Debt Yield = 6 % and Tax Rate = 35 %

Common Stock Price = $ 50, Expected Dividend = $ 2.5 and Growth Rate = 4 %

Let the cost of equity be k

k = (2.5/50) + 0.04 = 0.09 or 9 %

WACC = 9 x 0.6 + 6 x 0.4 x (1-0.35) = 6.96 %

Before analyzing the outcome of restructuring the firm's capital structure one needs to determine the new WACC under the restructured capital structure.

Debt = 0.6 and Equity = 0.4

New WACC = 0.6 x 6 x (1-0.35) + 0.4 x 9 = 5.94 %

As is observable, the new WACC of the firm is lower than its current WACC. This, in turn, implies that the CEO was in fact right in assuming that a higher level of debt depresses the firm's WACC. This happens due to the value accruing impact of the firm's increased (when debt increases from 40 % to 60%) debt's increased interest tax shield. A firm's long-term debts interest expenses are tax deductible which acts as a value enhancer for the firm. This increment in value is accompanied by a corresponding decline in the firm's WACC or discount rate as WACC and firm value are inversely related. However, increasing the debt continuously will lead to higher costs of debt and higher costs of equity because elevated debt levels lead to greater default risks, thereby elevating required returns (costs) of debt and equity. This, in turn, would increase WACC and lower firm value for very high levels of debt or debt beyond a certain threshold point. Hence, increasing debt lowers WACC and adds to value only to a certain tipping point. This tipping point is known as the optimal capital structure where the firm's value is the highest and its WACC the lowest. Any debt beyond the tipping point lowers firm value owing to risks of high debt and any debt below the tipping point leaves room for enhancing the firm value through debt increments.

My advice to the CEO would constitute telling him/her about this tipping point and elevate debt not beyond the same.