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 90​% debt. American Exploration currently has 5​% ​after-tax cost of debt and a 10​% 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 90​%? If​ so, how are they​ affected? Are the common stock claims riskier​ now?

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
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Chapter1: Investments: Background And Issues
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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 90​% debt. American Exploration currently has 5​% ​after-tax cost of debt and a 10​% 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 90​%? 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 14​%. 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?
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