Scenario: Wilson Corporation Is Not Real And Has A Ta 568671

Scenariowilson Corporation Not Real Has A Targeted Capital Structur

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.

Paper For Above instruction

Introduction

The Weighted Average Cost of Capital (WACC) is a critical metric for corporations as it represents the average rate that a company is expected to pay to finance its assets through both debt and equity. It serves as an essential benchmark for investment decisions, valuation, and understanding the firm's capital structure efficiency. This analysis explores Wilson Corporation’s current capital structure, computes its WACC utilizing the dividend discount model (DDM), and evaluates the implications of shifting from a 40% debt and 60% equity to a 60% debt and 40% equity configuration as proposed by the CEO.

Calculation of WACC Based on Current Capital Structure

Wilson Corporation maintains a target capital structure of 40% long-term debt and 60% equity. The debt component has a yield of 6%, with interest payments tax-deductible, resulting in a tax shield that reduces the effective cost of debt to the firm. The corporate tax rate is 35%. The equity segment is estimated using the dividend discount model, given the current dividend and growth rate.

The first step is to compute the cost of equity via the dividend discount model:

\[

\text{Cost of Equity} (r_e) = \frac{D_1}{P_0} + g

\]

where:

- \( D_1 = \$2.50 \) (next year's dividend),

- \( P_0 = \$50 \) (current stock price),

- \( g = 4\% = 0.04 \) (growth rate).

Plugging in the values:

\[

r_e = \frac{2.50}{50} + 0.04 = 0.05 + 0.04 = 0.09 \text{ or } 9\%

\]

Next, the after-tax cost of debt:

\[

r_d = \text{Yield} \times (1 - \text{Tax rate}) = 6\% \times (1 - 0.35) = 6\% \times 0.65 = 3.9\%

\]

The WACC is then calculated as:

\[

\text{WACC} = (w_d \times r_d) + (w_e \times r_e)

\]

where \( w_d = 0.40 \), \( w_e = 0.60 \):

\[

\text{WACC} = (0.40 \times 3.9\%) + (0.60 \times 9\%) = 1.56\% + 5.4\% = 7.56\%

\]

Therefore, Wilson Corporation's current WACC is approximately 7.56%.

Analysis of Changing the Capital Structure

The CEO suggests increasing debt from 40% to 60%, decreasing the equity proportion from 60% to 40%. The rationale is that higher debt levels, due to the tax shield, might lower the company’s overall WACC, making borrowing more attractive.

The new weights would be:

- 60% debt, with the after-tax cost remaining at 3.9%

- 40% equity, with the cost still at 9%

The recalculated WACC:

\[

\text{WACC} = (0.60 \times 3.9\%) + (0.40 \times 9\%) = 2.34\% + 3.6\% = 5.94\%

\]

This indicates that increasing debt to 60% would lower the WACC from 7.56% to approximately 5.94%.

Discussion and Defense of the Proposed Change

The proposition that increasing debt reduces WACC hinges on the tax shield benefit and the assumption that the firm can maintain its creditworthiness. The tax shield provided by debt financing is a well-documented advantage; interest payments are tax-deductible, and this reduces the overall tax liability, which can lead to substantial savings. Lower WACC enhances the firm's valuation, making projects more financially viable and increasing shareholder value (Modigliani & Miller, 1963).

However, increasing debt also introduces higher financial risk. With more debt, Wilson Corporation's fixed obligations increase, which could lead to financial distress if the company’s cash flows become insufficient to meet debt payments. Notably, a high debt ratio may lead to higher costs of debt and equity, as investors often perceive increased financial risk and demand higher returns (Myers, 2001). Moreover, the company's credit rating might deteriorate with higher debt, increasing future borrowing costs and possibly offsetting the tax shield benefits.

Given these opposing effects, the actual benefit of increasing debt depends on Wilson's operational stability, cash flow predictability, and industry conditions. If the firm has steady cash flows and a strong credit profile, the tax shield advantage could outweigh potential risks. Conversely, if cash flows are volatile, the increased leverage could escalate bankruptcy risk and raise the company's cost of debt over time.

Conclusion: Recommendations to the CEO

While the theoretical calculations underscore potential WACC reduction through leveraging, practical considerations advocate for caution. Based on the current data, increasing the debt to 60% might result in lower WACC, but the firm must assess its risk appetite and financial stability before making such a shift. It is advisable for Wilson Corporation to adopt a balanced approach, gradually increasing leverage while monitoring credit ratings and cash flow metrics.

Furthermore, Wilson should consider engaging in strategic financial planning, perhaps using scenario analysis to analyze different debt levels' impact on WACC and risk. It is essential for management to understand that a lower WACC does not automatically translate into higher firm value if the increased debt results in financial distress. Therefore, the optimal capital structure should balance tax benefits against financial risk, aligning with Wilson’s corporate strategy and operational realities.

In conclusion, while increasing debt could lower the WACC, it’s crucial to weigh the benefits against potential risks. Strategic financial management, coupled with vigilant risk assessment, will enable Wilson Corporation to leverage debt effectively without exposing itself to excessive financial distress risks.

References

• Modigliani, F., & Miller, M. H. (1963). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261-297.
• Myers, S. C. (2001). Capital Structure. Journal of Economic Perspectives, 15(2), 81-102.
• Damodaran, A. (2010). Applied Corporate Finance. John Wiley & Sons.
• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
• Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2013). Fundamentals of Corporate Finance. McGraw-Hill Education.
• Frank, M. Z., & Goyal, V. K. (2009). Capital Structure Decisions: Which Factors Are Reliably Important? Financial Management, 38(1), 1-37.
• Fama, E. F., & French, K. R. (2002). The Equity Premium. The Journal of Finance, 57(2), 637-659.
• Shapiro, A. C. (2013). Multinational Financial Management. John Wiley & Sons.
• Graham, J. R. (2000). How Big Are the Tax Benefits of Debt? Journal of Finance, 55(5), 1901-1941.
• Titman, S., & Wessels, R. (1988). The Determinants of Capital Structure Choice. The Journal of Finance, 43(1), 1-19.