Weighted average cost of capital 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 $80\%$ debt. American Exploration currently has $7\%$ after$-$tax cost of debt and a $14\%$ cost of common stock. The company does not have any preferred stock outstanding.

a$.$ What is American Exploration's current WACC?

b$.$ Assuming that its cost of debt and equity remain unchanged, what will be American Exploration's WACC under the revised target capital structure?

c$.$ Do you think shareholders are affected by the increase in debt to $80\%?$ If so$,$ how are they affected? Are the common stock claims riskier now?

d$.$ Suppose that in response to the increase in debt, American Exploration's shareholders increase their required return so that cost of common equity is $18\%.$ What will its new WACC be in this case?

e$.$ What does your answer in part $d$ suggest about the tradeoff between financing with debt versus equity?

a$.$ American Exploration's current WACC under the $50-50$ mix of debt and equity is $\%.($Round to two decimal places.$)$

b$.$ Assuming that its cost of debt and equity remain unchanged, American Exploration's WACC under the revised target capital structure of $80\%$ debt and $20\%$ equity is $\%.($Round to two decimal places.$)$

c$.$ Do you think shareholders are affected by the increase in debt to $80\%?$ If so$,$ how are they affected? $($Select the best answer below.$)$

A$.$ Yes, shareholders benefit from the increase of debt financing because the interest expenses paid to bondholders are tax exempt.

B$.$ No$,$ only bondholders are affected because there is a greater chance that the firm may not be able to make the interest payments.