About Your Signature Assignment 923687
About Your Signature Assignmentthis Signature Assignment Is Designed T
Scenario: Wilson Corporation (not real) has a targeted capital structure of 40% long term debt and 60% common stock. The debt is yielding 6% and the corporate tax rate is 35%. The common stock is trading at $50 per share and next year's dividend is $2.50 per share that is growing by 4% per year. Prepare a minimum 700-word analysis including the following: Calculate the company's weighted average cost of capital. Use the dividend discount model. Show calculations in Microsoft® Word. The company's CEO has stated if the company increases the amount of long term debt so the capital structure will be 60% debt and 40% equity, this will lower its WACC. Explain and defend why you agree or disagree. Report how would you advise the CEO. Format your paper consistent with APA guidelines.
Paper For Above instruction
The capital structure of a firm significantly influences its cost of capital and overall valuation. Wilson Corporation's current structure, with 40% long-term debt and 60% equity, offers a foundation to analyze the effects of altering debt levels on the weighted average cost of capital (WACC). This analysis employs the dividend discount model (DDM) for equity valuation and considers the implications of increasing debt to 60%. The central question revolves around whether boosting debt ratio will reduce the company's WACC, thereby potentially enhancing firm value.
Calculating the Weighted Average Cost of Capital (WACC)
The WACC combines the cost of equity and the cost of debt, weighted by their proportions in the firm's capital structure. Its calculation follows the formula:
WACC = (E/V) Re + (D/V) Rd * (1 - Tc)
Where:
- E = Market value of equity
- D = Market value of debt
- V = E + D = Total firm value
- Re = Cost of equity
- Rd = Cost of debt (yield on debt)
- Tc = Corporate tax rate
Given data includes:
- Debt yield (Rd): 6%
- Tax rate (Tc): 35%
- Equity price: $50 per share
- Next year's dividend (D1): $2.50
- Dividend growth rate (g): 4%
Calculating Cost of Equity (Re) Using the Dividend Discount Model
The dividend discount model (Gordon Growth Model) estimates Re as:
Re = (D1 / P0) + g
Substituting the known values:
Re = ($2.50 / $50) + 0.04 = 0.05 + 0.04 = 0.09 or 9%
Determining the Market Values of Equity and Debt
Since the current market value of equity (E) is based on the stock price:
E = Number of shares * Price per share
> Assuming the number of shares is not specified, we consider the proportion. The total value (V) is split as 60% equity and 40% debt.
For simplicity, let’s consider a hypothetical total firm value, such as $1,000,000. Then:
- Equity (E): 60% of $1,000,000 = $600,000
- Debt (D): 40% of $1,000,000 = $400,000
Applying the WACC formula:
WACC = (E/V) Re + (D/V) Rd (1 - Tc) = 0.60 0.09 + 0.40 0.06 (1 - 0.35) = 0.054 + 0.0156 = 0.0696 or approximately 6.96%
Impact of Changing Capital Structure from 40% Debt to 60% Debt
The firm's management proposed increasing leverage from 40% to 60%. To analyze this, we need to recalculate the WACC assuming the new structure:
- New equity proportion: 40%
- New debt proportion: 60%
Using the same assumptions regarding debt and equity costs, the new WACC would be:
WACC = 0.40 0.09 + 0.60 0.06 * (1 - 0.35) = 0.036 + 0.0624 = 0.0984 or about 9.84%
This calculation indicates that increasing debt increases the WACC, contrary to the assertion that it would decrease. The key reason is that while debt can be cheaper (due to tax shields), excessive leverage raises financial risk, which can increase the equity cost and overall WACC.
Analysis of the CEO’s Assertion
The CEO believes that increasing debt to 60% will lower WACC, primarily due to the tax shield benefits on debt interest. While debt interest is tax deductible, the increased leverage also elevates financial risk and can lead to higher costs of equity as investors demand greater returns for increased risk. This risk can outweigh tax benefits, causing WACC to rise.
Recommendations and Defense
Based on the analysis, I would advise the CEO against increasing debt to 60%. The initial calculations show that WACC would actually increase, diminishing firm value. Optimal capital structure involves balancing debt benefits with the increased financial risk. A moderate level of debt—less than 60%—may offer taxation benefits without significantly escalating risk.
Additionally, the firm should consider other factors such as industry standards, credit ratings, and market conditions before altering leverage. Maintaining a prudent balance prevents financial distress and sustains investor confidence.
Conclusion
In conclusion, while increasing leverage can provide tax advantages, excessive debt raises financial risk and can lead to higher overall costs, including the WACC. The current and revised calculations suggest that maintaining a moderate leverage level is more beneficial for Wilson Corporation. The decision to alter capital structure should be carefully evaluated in the context of risk, cost of capital, and firm strategy.
References
- Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
- Damodaran, A. (2015). Applied Corporate Finance (4th ed.). John Wiley & Sons.
- Ross, S. A., Westerfield, R., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
- Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
- Higgins, R. C. (2018). Analysis for financial management (11th ed.). McGraw-Hill Education.
- Frank, M. Z., & Goyal, V. K. (2009). Capital structure decisions: Which factors are reliably important? Financial Management, 38(1), 1-37.
- Myers, S. C. (2001). Capital structure. Journal of Economic Perspectives, 15(2), 81-102.
- Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance, and the theory of investment. American Economic Review, 48(3), 261-297.
- Titman, S., & Wessels, R. (1988). The determinants of capital structure choice. Journal of Finance, 43(1), 1-19.
- Kraus, A., & Litzenberger, R. H. (1973). A state-preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922.