Question

0 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 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? 8. 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.) b. Assuming that its cost of debt and equity remain unchanged. American Exploration's WACC under the revised target capital structure of 70% debt and 30% equity is %. (Round to two decimal places.) c. Do you think shareholders are affected by the increase in debt to 70%? If so, how are they affected? (Select the best answer below.) O A. No, shareholders have the right to increase their required rate of return, which in tum may lower the firm's risk of bankruptcy. OB. Yes, their common stock claims are riskier now because larger interest expenses must be paid prior to any dividend payment. OC. No. only bondholders are affected because there is a greater chance that the firm may not be able to make the interest payments. OD. Yes, shareholders benefit from the increase of debt financing because the interest expenses paid to bondholders are tax exerript. d. If, in response to the increase in debyt, American Exploration's shareholders increase their required retum so that cost of common equity is 18%, the new WACC in this case is % (Round to two decimal places.) e. What does your answer in part d suggest about the tradeoff between financing with debt versus equity? (Select from the drop-down menus.) Increasing the percentage of debt financing the risk of the company not being able to make its interest payments and can lead to shareholders increasing their required return which raises the cost of equity capital.

Answer 1

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11 Q ENG 05:25 30-07-2020 99+ 31 X x DR307 fc > . DO DP DO DR DS DT DU DV DW DX DY DZ EA 287 AMERICAN EXPLOSIVE 288 289 290 291 292 a WACC = We*ke + Wd*kd*(1-t) 50%*14% + 50%*7% WACC = 293 WACC = 10.50% 294 295 296 b WACC = 30%*14% + 70%*7% 9.10% WACC = 297 с OPTION B YES, RISKIER BECAUSE HIGHER INTEREST EXPENSES ARE TO BE PAID WHICH WILL REDUCE INCOME AVAILABLE TO EQUITY HOLDERS d WACC = 298 299 300 301 302 303 304 305 306 307 308 30%*18% + 70%*7% 10.30% WACC = e INCREASE 309 310 DGM beta VAR port future INDEX WACC HEDGE INTL CAP BUD Sheet11 SANDRINE LEASING PORTFOLOQ | DIR right clean ... +