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    The firm is considering changing its target capital structure from a 50-50 mix of debt and equity to 70% debt. Currently, the firm's after-tax cost of debt is 6% and cost of equity is 12%. If it maintains these costs but changes the capital structure to 70% debt, its WACC will decrease. Shareholders will be negatively affected by the increased risk from higher debt as their equity claims become riskier. If the increased debt causes the required equity return to rise to 16%, the firm's new WACC will be higher than under the initial 70% debt target. Generally, using more debt lowers the WACC but increases risk, while using more equity raises the WACC but lowers risk.

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    finance

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    CASE 1 (1)

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    The firm is considering changing its target capital structure from a 50-50 mix of debt and equity to 70% debt. Currently, the firm's after-tax cost of debt is 6% and cost of equity is 12%. If it maintains these costs but changes the capital structure to 70% debt, its WACC will decrease. Shareholders will be negatively affected by the increased risk from higher debt as their equity claims become riskier. If the increased debt causes the required equity return to rise to 16%, the firm's new WACC will be higher than under the initial 70% debt target. Generally, using more debt lowers the WACC but increases risk, while using more equity raises the WACC but lowers risk.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
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    4 views1 page

    Case 1

    Uploaded by

    Memo Ner
    The firm is considering changing its target capital structure from a 50-50 mix of debt and equity to 70% debt. Currently, the firm's after-tax cost of debt is 6% and cost of equity is 12%. If it maintains these costs but changes the capital structure to 70% debt, its WACC will decrease. Shareholders will be negatively affected by the increased risk from higher debt as their equity claims become riskier. If the increased debt causes the required equity return to rise to 16%, the firm's new WACC will be higher than under the initial 70% debt target. Generally, using more debt lowers the WACC but increases risk, while using more equity raises the WACC but lowers risk.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
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    of 1

    Q: A firm 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. The firm 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 the firm’s current WACC?

    b. Assuming that its cost of debt and equity remain unchanged, what will be the firm’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, the firm’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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