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 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 70%? If so, how are they affected? Are their 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 b suggest about the tradeoff between financing with debt versus equity?
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