Overview

Wildcat Pizza, Inc. 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 70% debt.Wildcat currently has 6% after-tax cost of debt and a 12% cost of common stock. The company does not have any preferred stock outstanding.

1. What is Wildcat's current WACC?
2. Assuming that its cost of debt and equity remain unchanged, what will be Wildcat's WACC under the revised target capital structure?
3. In your opinion, are shareholders affected by the increase in debt to 70%? Are their common stock claims riskier now?Why or why not?
4. Suppose that in response to the increase in debt, Wildcat shareholders increase their required return so that the cost of common equity is 16%. What will Wildcat's new WACC be in this case?
5. What does your answer in part 2 suggest about the tradeoff between financing with debt versus equity?