Question

Homework: Chapter 9 Homework Save score: 0 of 1 pt 10 of 10 (4 complete) HW Score: 20% , 2 of 10 pt P9-20 (similar to) Question Help Weighted average cost of capital American Exploration, Inc., a natural gas producer, is trying too 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 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 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 70%? 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? a. American Exploration's current WACC under the 50-50 mix of debt and equity is %. ( Round to two decimal places.)

If you could also upload the excel file or screen shot the excel work that would be helpful to learn how to do the problem myself in the future ! Thank you !

Answer 1

The WACC formula is: WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

1. 0.50 x 14% + 0.50 x 7% = 10.50%
2. 0.30 x 14% + 0.70 x 7% = 9.10%
3. Yes, their common stock claims are riskier now because larger interest expenses must be paid prior to any dividend payment
4. 0.30 x 18% + 0.70 x 7% = 10.30%
5. Increasing the percentage of debt financing increases the risk of the company not being able to make its interest payments and can lead to shareholder in increasing their required return which raises the cost of equity capital.