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Q1, American? Exploration, Inc, a natural gas? producer, is trying to decide whether to revise its target capital structure
Q1, 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 70?% debt. American Exploration currently has 6?% after-tax cost of debt and a 12?% cost of common stock. The company does not have any preferred stock outstanding. (2 Marks)
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 70?%? 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 16?%. What will its new WACC be in this? case?
Q2. What is the significance of voting rights to the ordinary shareholders? What is a proxy? Why do proxy fights occur? (1 Mark)
Q3. Briefly explain the factors that influence the planning of the capital structure in practice. (1 Mark)
Q4. ‘Bonus shares represent simply a division of corporate pie into a large number of pieces.’ Explain. (1 Mark)
Expert Solution
weight of equity (We) = 50%
Weight of Debt (Wd) = 50%
Kd= 6%
Ke = 12%
Target capital structure = 70% Debt
a. Current WACC:
(We * Ke) + ( wd * Kd) = 0.5*12 + 0.5*6
= 6 + 3
= 9%
b. Revised WACC ( when Wd = 70%):
= (0.3 * 12) + (0.7 * 6 )
= 3.6 + 4.2
= 7.8%
c. Increase in Debt to 70% affecting shareholders:
1. As the debt increases shareholders require higher returns since they face higher financial risk. Shareholders risk increases as larger amounts of interest are committed to be paid to creditors from firms operating cashflows.
2. Increase in financial risk will increase the ß of the Firms stock.Increased ß reflects the Increased risk.
3. The additional risk premium shareholders require for this additional financial risk increases directly with this firms debt equity ratio.
d. If Ke increases to 16% new WACC:
(We * Ke) + ( wd * Kd) = 0.3 * 16 + 0.7 * 6
= 4.8 + 4.2
= 9%
2. Significance of voting rights to ordinary Shareholders:
Single Share denotes one vote,which might be concerning company policies or election of directors.
Voting rights helps in participating in major company decisions.
Proxy :
An individual with legal authorisation to vote on behalf of a company shareholder.
Reasons for Proxy Fights:
Situation in which a group of shareholders in a company joins forces in an attempt to oppose and vote out the current management.
Proxy fight is a battle between shareholders and senior management for control of the company.
Commonly inititated by dissatisfied shareholders of the company.
3. Factors influencing the planning of the capital structure:
Financial Leverage or trading on equity
Expected cash flows
Stability of shares
Control over the company
Flexibility of Financial structure
Cost of floating the capital
Period of financing.
4. Bonus shares:
Bonus shares are additional shares given to the current shareholders without any additional cost based upon the number of shares that a shareholder owns.
The basic principle behind bonus shares is that the total number of shares increases with a constant ratio of number of shares held to the number of shares outstanding.
Company issue bonus shares to encourage retail participation and increase their share Base.
Increase in number of shares reduce the price per share.But the overall capital remains the same even if the bonus shares are declared.
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