Capital structure: Pepe's Pizza is looking toward the future and is considering revising its target capital structure. Currently, they utilize a 50-50% mix of debt and equity but are considering a target capital structure with 70% debt. This will allow Pepe's Pizza additional leverage for purchasing some capital equipment. Remember the capital structure will always equal 100% in total. Cost of capital: Wildcat currently has a cost of debt at 6% and a cost of equity at 12%.

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Questions:

In your responses when deciding whether to invest in a capital project, remember the projects profit should exceed the Weighted Average Cost of Capital (WACC) to be a profitable project for Pepe's Pizza. (Be sure to address each question fully, you may be asked to calculate the WACC and explain whether Pepe's Pizza should invest and explain why or why not)

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1. Please calculate Pepe's Pizza current WACC (Weighted Average Cost of Capital) using the 50-50% mix?

Given the current WACC, if Pepe's were to invest in a capital improvement project to purchase a new pizza oven, which will improve efficiency and generate a profit of 8% should they invest in this equipment? Why or why not?

2. Assuming that its cost of debt (6%) and equity (common stock 12%) remain unchanged, what will be Pepes WACC under the revised target capital structure of 70% debt?

With the new WACC, should Pepe's still purchase the new pizza oven with an 8% profit rate, and why?

3. Which shareholders are most affected by the increase in debt to 70% and why? Are common stock claims riskier now? Why or why not?

4. Suppose that in response to the increase in debt, Pepe's shareholders increase their required return so that the cost of common equity is 16%. What will Pepes new WACC be in this case?

5. Please provide a two-paragraph response explaining what your answers suggest about the differences between the capital structure of a business financing with debt versus equity? Be sure to consider the impact of risk increasing debt and how this can influence shareholder confidence in a company.