Question

American​ Exploration, Inc., a natural gas​ producer, is trying to decide whether to revise its target capital structure. Currently it targets a 50​-50mix of debt and​ equity, but it is considering a target capital structure with 80​% debt. American Exploration currently has 6​% after-tax cost of debt and a 12​% 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 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 16​%. 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?

Answer 1