Exploration, Inc., a natural gasproducer, is trying to decide whether to revise its target capital structure. Currently it targets a 50-50 mix of debt andequity, but it is considering a target capital structure with 90% debt. 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 isExploration's currentWACC?

b.Assuming that its cost of debt and equity remainunchanged, what will beExploration's WACC under the revised target capitalstructure?

c.Do you think shareholders are affected by the increase in debt to 90%? Ifso, how are theyaffected? Are the common stock claims riskiernow?

d.Suppose that in response to the increase indebt,Exploration's shareholders increase their required return so that cost of common equity is 16%. What will its new WACC be in thiscase?

e.What does your answer in part d suggest about the tradeoff between financing with debt versusequity?

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