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.  

In order to calculate the company’s weighted average cost of capital (WACC), we first need to determine the cost of each component of the company’s capital structure: the cost of debt and the cost of equity.

The cost of debt for Wilson Corporation can be calculated using the following formula:

Cost of Debt = (Yield to Maturity x (1 – Tax Rate))

In this case, the yield to maturity on the company’s debt is 6%, and the corporate tax rate is 35%. So, the cost of debt for Wilson Corporation is:

Cost of Debt = (0.06 x (1 – 0.35)) = 0.039 or 3.9%

Next, we need to determine the cost of equity for the company. One common method for calculating the cost of equity is the Dividend Discount Model (DDM). The DDM calculates the cost of equity by assuming that the value of a stock is equal to the present value of all future dividends. The formula for the DDM is as follows:

Cost of Equity = (Next Year’s Dividend / Stock Price) + Growth Rate

In this case, next year’s dividend is $2.50 per share, and the stock price is $50 per share. The growth rate is 4% per year. So, the cost of equity for Wilson Corporation is:

Cost of Equity = ($2.50 / $50) + 0.04 = 0.05 or 5%

Once we have the cost of debt and the cost of equity, we can calculate the WACC using the following formula:

WACC = (Cost of Debt x (Debt / (Debt + Equity))) + (Cost of Equity x (Equity / (Debt + Equity)))

In this case, the company’s targeted capital structure is 40% long-term debt and 60% common stock, so:

WACC = (0.039 x (0.4 / (0.4 + 0.6))) + (0.05 x (0.6 / (0.4 + 0.6))) = 0.0436 or 4.36%

The CEO has stated that 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. In theory, this statement is correct because the cost of debt is typically lower than the cost of equity, so increasing the proportion of debt in the capital structure should lower the WACC. However, it is important to consider the implications of this change on the company’s risk profile. Increasing the amount of debt also increases the company’s financial leverage, which can increase its risk of default. Additionally, if the company’s credit rating is lowered due to the increased debt, it may have to pay a higher interest rate on that debt, offsetting the potential reduction in the WACC.

Based on this, I would advise the CEO to carefully consider the trade-offs involved in increasing the company’s debt levels. If the company can maintain its credit rating and manage the additional risk, then increasing the debt may be a viable strategy to lower the WACC. However, if the company’s credit rating is likely to be affected or the company is unable to manage the additional risk, then it may be better to maintain the current capital structure. It is also important to consider other factors that may affect the company’s WACC such as liquidity, currency and market risks.

In conclusion, while increasing the amount of long-term debt in the capital structure can lower the WACC, it is important to consider the implications on the company’s risk profile and credit rating.