Question

Recently, Wooster Food (WF) states that they plan to increase the proportion of debt in the company’s capital structure. You are concerned that any changes in WF’s capital structure will negatively affect the value of investment. You gathers the information about WF given in Exhibit 1.

Exhibit 1. Current Selected Financial Information for WF

Yield to maturity on debt	8.00%
Market value of debt	$100 million
Number of shares of common stock	10 million
Market price per share of common stock	$30
Cost of capital if all equity-financed	10.3%
Marginal tax rate	35%

You expect that an increase in WF’s financial leverage will increase its costs of debt and equity. Based on an examination of similar companies in WF’s industry, you estimate WF’s cost of debt and cost of equity at various debt-to-total capital ratios, as shown in Exhibit 2. Exhibit 2. Estimates of WF’s before Tax Costs of Debt and Equity

Deb-to-Total Capital Ratio (%)	Cost of Debt (%)	Cost of Equity (%)
20	7.7	12.5
30	8.4	13.0
40	9.3	14.0
50	10.4	16.0

What is the current capital structure of WF? (Hint: calculate the percentages of debtfinancing and equity-financing) (2 pts)

Based on Exhibits 1 and 2, what is the current after-tax cost of debt for WF? (2 pts)

Based on Exhibits 1 and 2, what is the current cost of equity for WF? (4 pts)

Based on Exhibits 1 and 2, what debt-to-total capital ratio would minimize WF’s weighted average cost of capital? (2 pts)

Holding operating earnings constant, how will the cost of capital change after an increase in marginal tax rate to 40 percent? (2 pts)

According to the pecking order theory, what do you think about the announced capital structure change of WF? (2 pts)

Answer 1

1. Market value of debt = $100 million

Market value of equity = 10M x $30 = $300 million

Capital structure thus consists of 75% equity and 25% debt at 1:3 debt equity ratio

2. Since current debt percentage is 25% for WF, we will take an average of 20 and 30% from exhibit 2 to arrive at after tax cost of debt

7.7 + 8.4 /2 x (1-0.35) = 5.23%

3. We will again take an average of 20 and 30% debt to total capital situation cost of equity which is 12.5 and 13% = 12.75%

4. This you can calculate on your own by calculating WACC for each debt to capital ratio

5. The cost of capital will come down owing to an increase in tax rate to 40% because interest cost will come down. Thus cost of debt will reduce and so is the overall cost of capital.

6. In pecking order theory equity financing is looked down upon because of outside investors' views that the company is overvalued and hence wants to issue new equity. This theory prefers the order of financing as internal funds, debt and the last resort as issue of new equity. Thus from the perspective of this theory, the announced capital structure change is perfect as it plans to increase the proportion of debt.