Upjohn, also a major pharmaceutical company, is considering increasing its debt ratio from 15% to 30%, which is its optimal debt ratio. Its beta is 1.50, and the current Treasury bond rate is 6.50%. ERP is 5.5%. The return on equity was 10.5% in the most recent year, and it is dropping as health care matures as a business. The company has instituted restrictive anti-takeover measures.

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 not a takeover target

b) Invest in projects since return on equity is higher than cost of equity.

b.

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

c.

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.

d.

a) Gradually, because company is not a takeover target

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