Question

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 90% 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 90%? 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

Answer A:

Current mix of debt and equity = 50 - 50 mix

Hence weight of debt = 50% and weight of equity = 50%

cost of debt = 5% and cost of equity = 10%

WACC = WeRe + WdRd (1-t)

where We = weight of equity, Wd = weight of debt

Re = cost of equity, Rd(1-t)= after tax cost of debt

WACC = 0.5*0.1 + 0.5*0.05

= 0.075 = 7.5%

Answer B:

Target Capital Structure : 90% debt

Revised weights : Weight of debt = 90% , weight of equity = 10%

WACC = 0.1*0.1 + 0.9*0.05

= 0.055 = 5.5%

Answer C

Yes, shareholders are affected by increasing debts to 90%. With the debt percentage increasing to 90%, the interest expense burden of the firm will increase thus making the the net income fall and less profit attributable to share holders and EPS.

Also, when a company is a 90% debt company, the asset class becomes riskier as compared to a 50% debt company, because it brings down the profitability / returns for equity holders. Also interest on debt will always be paid off irrespective of revenue growth or decline, income after tax is positive or negative. However risk of negative income increases with high debts so risk for common share holders increases.

Answer D

Weight of Revised Debt = 90%, Weight of Equity = 10%

Cost of Debt = 5%, Revised cost of equity = 14%,

WACC = 0.1*0.14 + 0.9*0.05

= 0.059 = 5.9%

Answer E

For company in short term this trade off is profitable because previous cost on equity was 10% and cost of debt is 5%, half of the equity. WACC was 7.5% with both Equity and Debt 50% of ratio. With new structure of 90% debt WACC is 5.9% if cost of equity is 14% so overall cost of capital WACC is reduced.

However on paper and in short term such capital structure can looks good as WACC is less but in long term it's harmful for the organization.

Hope this helps, thanks and have a good day. Feel free to share your feedback.