• P924 WEIGHTED AVERAGE COST OF CAPITAL (WACC) American Exploration Inc., a natural gas producer, 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. American Exploration currently has a 6% after-tax cost of debt and a 12% cost of common stock. The company does not have any preferred stock outstanding.
  • What is American Explorations current WACC?
  • Assuming that its cost of debt and equity remain unchanged, what will be American Explorations WACC under the revised target capital structure?
  • Do you think that shareholders are affected by the increase in debt to 70%? If so, how are they affected? Are their common stock claims riskier now?
  • Suppose that in response to the increase in debt, American Explorations shareholders increase their required return so that the cost of common equity is 16%. What will its new WACC be in this case?
  • What does your answer in part b suggest about the tradeoff between financing with debt versus equity?