Weighted Averge Cost of Capital. Amex, Inc. a natural gas producer, is trying to

Question

Weighted Averge Cost of Capital. Amex, 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 equity, but it is considering a target 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 the American exploration's current WACC?

b. Assuming that its cost of debt and equity remain unchanged, what will be american Explorations WACC under the revised target capital structure?

c. Do you think share holders 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 share holders increase their required return so that cost of common equity is 18%. What will its new WACC be in the case?

Explanation / Answer

a) Current WACC = wd x kd x (1 - tax) + we x ke = 50% x 7% + 50% x 14% = 10.50%

b) New WACC = 70% x 7% + 30% x 14% = 9.10%

c) Yes, shareholders are affected because of the increase in debt. Higher leverage firms are more risky and higher probability of default and hence, cost of equity typically increases as well in order to compensate for higher risk.

d) New WACC = 70% x 7% + 30% x 18% = 10.30%

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