Upjohn, also a major pharmaceutical company, is considering increasing its debt ratio from 11% to 40%, which is its optimal debt ratio. Its beta is 1.17, and the current Treasury bond rate is 6.50%. ERP is 5.5%. The return on equity was 14.5% in the most recent year, but it is dropping as health care matures as a business. The company has also been mentioned as a possible takeover target and is widely held.

a. Would you suggest that Upjohn move to the optimal ratio immediately? Explain.

b. How would you recommend that Upjohn increase its debt ratio?

a.

a) Gradually, because company is a takeover target

b) Buy back shares or pay special dividend since return on equity is lower than the cost of equity (15.935%)

b.

a) Gradually, because company is a takeover target

b) Invest in projects since return on equity 14.5% is dropping but still higher than cost of equity of 10.25%

c.

a) Immediately, because company is a takeover target

b) Buy back shares or pay special dividend since return on equity is dropping relative to cost of equity (12.935%)

d.

a) Immediately, because company has a very low debt ratio

b) Invest in projects since return on equity is dropping relative to cost of equity (12.935%)