Assuming The Same Capital Structure Is To Be Maintained, Wha

Assuming the same capital structure is to be maintained, what is the optimal capital structure for Canyon Drilling? What is the component cost of capital for the firm? Calculate Canyon Drilling’s after tax weighted average cost of capital, using the information above.

Canyon Drilling Inc., which has recently come under new management, seeks to determine its optimal capital structure and the cost of additional funding if required. The company's current capital structure includes debt, common equity, and preferred stock, with specified market values, costs, and flotation costs. The key is to evaluate the components of the firm's weighted average cost of capital (WACC) and determine the optimal mix of debt and equity that minimizes the overall cost of capital while maintaining the current structure. This involves calculating the component costs of debt, equity, and preferred stock, considering taxes and flotation costs, and then computing the after-tax WACC.

Component Cost of Capital for Each Financing Source

Firstly, the cost of debt (Kd) must be determined. Since bonds are traded at a premium ($1,050 vs. $1,000 par), the yield to maturity (YTM) is calculated considering annual coupon payments, current market price, and maturity period. Using the YTM formula or a financial calculator, the approximate YTM for the bonds is determined to be approximately 6.09%. The after-tax cost of debt (Kd(1 - T)) is then computed by adjusting for the corporate tax rate of 40%, resulting in an after-tax cost of approximately 3.65%. This low after-tax cost is advantageous as debt provides tax shields.

For equity, the cost of equity (Ke) is estimated using the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, beta, and market risk premium. Applying the CAPM formula: Ke = Rf + β (Market Risk Premium), yields Ke = 4% + 1.15 × 7% = 4% + 8.05% = 12.05%. This represents the return required by equity investors, matching the company's risk profile.

The cost of preferred stock (Kp) is derived by dividing the annual preferred dividend by the net price after flotation costs. The annual dividend is 5% of $100 par, or $5 per share. Adjusting for flotation costs of 5%, the net issuing price per preferred stock is $80, resulting in a component cost of 6.25% ($5 / $80). This cost is fixed by the dividend rate and market price.

Market Values and Weights for Capital Components

The total market value of each component is crucial for weighting in the WACC calculation:

• Debt: 3,600 bonds × $1,050 = $3,780,000
• Equity: 40,000 shares × $50 = $2,000,000
• Preferred Stock: 7,500 shares × $80 = $600,000

The total market value of the firm's capital structure is thus $3,780,000 + $2,000,000 + $600,000 = $6,380,000. The weights are calculated as each component divided by the total:

• Debt weight (Wd): $3,780,000 / $6,380,000 ≈ 59.3%
• Equity weight (We): $2,000,000 / $6,380,000 ≈ 31.3%
• Preferred stock weight (Wp): $600,000 / $6,380,000 ≈ 9.4%

Calculating the Weighted Average Cost of Capital (WACC)

The WACC formula combines the components with their respective weights:

WACC = (Wd × Kd(1 - T)) + (We × Ke) + (Wp × Kp)

Plugging in the figures:

WACC = (0.593 × 3.65%) + (0.313 × 12.05%) + (0.094 × 6.25%)

= 2.17% + 3.77% + 0.59% ≈ 6.53%

This WACC represents the company's overall cost of capital, considering the current capital structure and market conditions. It serves as a benchmark for evaluating new projects and financing decisions.

Maintaining the Current Capital Structure and Implications

Given that the chief financial officer intends to maintain the existing capital structure, the calculation of WACC indicates the optimal mix that minimizes the firm's overall cost of capital. The high proportion of debt, which has a relatively low after-tax cost, suggests that leveraging enhances value by reducing the firm's weighted cost of capital. However, company management must balance the benefits of debt against the risks of financial distress. The calculated WACC of approximately 6.53% provides a target for evaluating prospective investments and determining the feasibility of raising additional capital.

Conclusion

In conclusion, the optimal capital structure for Canyon Drilling, given the current market values and costs, involves approximately 59.3% debt, 31.3% equity, and 9.4% preferred stock. The component costs are approximately 3.65% for debt (after tax), 12.05% for common equity, and 6.25% for preferred stock. The firm's overall weighted average cost of capital thus approximates 6.53%, serving as a vital metric for assessing expansion opportunities, refinancing, and strategic investments. Maintaining this structure would allow Canyon Drilling to optimize its cost of capital, enhance value for shareholders, and effectively leverage its financial position.

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