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 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 7070​%? 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 a
Component	Cost		Weight	Cost * Weight
Debt	5.00%		50.00%	2.50%
Equity	10.00%		50.00%	5.00%
			WACC	7.50%
Solution b
Component	Cost		Weight	Cost * Weight
Debt	5.00%		70.00%	3.50%
Equity	10.00%		30.00%	3.00%
			WACC	6.50%
Solution c
Yes, if the debt is increased in capital structure, the equity shareholder gets impacted. The reason behind this is debts will be having the first claim on the company's assets in case the company goes into liquidation
. To deal with this increased risk, equity will increase its expected return.
Solution d
Component	Cost		Weight	Cost * Weight
Debt	5.00%		70.00%	3.50%
Equity	14.00%		30.00%	4.20%
			WACC	7.70%
Solution e
As we can see that the original cost of equity was 10% but as the company increased debt in capital structure, which makes shareholders claim riskier
the shareholders increased their cost of equity from 10% to 14% which in effect taken away the benefit of reducing WACC using low-cost debt. So we can conclude
that changing capital structure will not change the WACC of the company much because as low-cost debt is increased, the shareholders increase their cost to compensate
for the additional risk being born by shareholders which nullifies the impact of low-cost debt and WACC remains in the same range.