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 7% after-tax cost of debt and a 14% 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 equity remain unchanged, what will be American Exploratino'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 18%. 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?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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 7% after-tax cost of debt and a 14% cost of common stock. The company does not have any
A. What is American Exploration's current WACC?
B. Assuming that its
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 18%. 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?
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