3. Plastico is considering a major change in its capital structure.

It has three options:

Option 1: Issue $1 billion in new stock and repurchase

half of its outstanding debt. This will make it an

AAA-rated firm (AAA rated debt is yielding 11% in

the marketplace).

Option 2: Issue $1 billion in new debt and buy back

stock. This will drop its rating to A. (A rated debt

is yielding 13% in the marketplace).

Option 3: Issue $3 billion in new debt and buy back

stock. This will drop its rating to CCC (CCC rated

debt is yielding 18% in the marketplace).

a. What is the cost of equity under each option?

b. What is the after-tax cost of debt under each

option?

c. What is the cost of capital under each option?

d. What would happen to (i) the value of the firm; (ii)

the value of debt and equity; and (iii) the stock price

under each option if you assume rational stockholders?

(You can assume no growth in perpetuity)

e. From a cost of capital standpoint, which of the three

options would you pick or would you stay at your

current capital structure?

f. What role (if any) would the variability in Plasticos

income play in your decision?

g. How would your analysis change (if at all) if the

money under the three options were used to take

new investments (instead of repurchasing debt or

equity)?

h. What other considerations (besides minimizing the

cost of capital) would you bring to bear on your decision?

i. Intuitively, why does not the higher rating in Option

1 translate into a lower cost of capital?