Kris Corporation is a leading automobile manufacturer. The balance sheet of the company is as follows (in millions):

Assets

Fixed Assets

Current Assets

Liabilities

4000

1000

Debt

Equity

2500

2500

Kris currently has 50 million shares outstanding. The book value per share is $50, while the current market price is $80 per share. Kris pays a dividend of $4 per share and has a price/earnings ratio of 10. The stock currently has a beta of 1.2. The debt of Kris Corporation is in the form of long-term bonds with a coupon rate of 10%. The bonds are currently rated AA and are selling at a yield of 12%. The market value of the bonds is 80% of the face value.

Kris 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).

The board of Kris Corporation is interested in how it compares with its competitors in the same industry when evaluating its capital structure. The table below shows the current Variance in Income, Tax Rate, and R&D/Sales of Kris Corporation and the mean values of its industry peers.

Kris Corporation

Other Competitors

Variance in Income

Marginal Tax Rate

R&D/Sales

40%

40%

12%

20%

40%

8%

5 The risk-free rate is 8% and the market risk premium is 5.5%. The corporate marginal tax rate is 40%. The company has no preferred stock.

a. Estimate the current cost of capital for Kris.

b. Estimate the current cost of capital for Kris under each option.

c. From a cost of capital standpoint, which of the three options would you pick? Or would you stay with the current capital structure?

d. The variability in Kris's income is higher than its industry peers. Will this fact affect whether Kris takes on the additional debt?

e. Kris's research and development (R&D) expenses are higher than its industry peers.

Will this fact affect whether Kris takes on the additional debt?

f. Why doesn't the higher rating in Option 1 translate into a lower cost of capital?

g. Based on the business that Kris operates in, discuss the potential indirect bankruptcy costs that may accrue to Kris's business. What role (if any) would the indirect bankruptcy costs play in Kris's capital structure decision?