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Wildcat Pizza, Inc. 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. Wildcat currently has 6% after-tax cost of debt and a 12% cost of common stock. The company does not have any preferred stock outstanding.
Problem 1: What is Wildcat's current WACC?
Problem 2: Assuming that its cost of debt and equity remain unchanged, what will be Wildcat's WACC under the revised target capital structure?
Problem 3: In your opinion, are shareholders affected by the increase in debt to 70%? Are their common stock claims riskier now? Why or why not?
Problem 4: Suppose that in response to the increase in debt, Wildcat shareholders increase their required return so that the cost of common equity is 16%. What will Wildcat's new WACC be in this case?
Problem 5: What does your answer in part 2 suggest about the tradeoff between financing with debt versus equity?
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