Problem $3$

Rubberman is considering a major change in its capital structure. It has three options:

Option $1$: Issue $S1$ billion in new stock and repurchase half of its outstanding debt. This will

make it an AAA rated firm. $($AAA rated debt is yielding $11\%$ in the marketplace.$)$

Option $2$: Issue S$1$ billion in new debt and buy back stock. This will drop its rating to A$-.($A

rated debt is yielding $13\%$ in the marketplace.$)$

Option $3$: Issue $$3$ billion in new debt and buy back stock. This will drop its rating to CCC$.$

$($CCC rated debt is yielding $18\%$ in the marketplace.$)$

a$.$ What is the cost of equity under each option?

b$.$ What is the after$-$tax cost of debt under each option?

c$.$ What is the cost of capital under each option?

d$.$ What would happen to $($a$)$ the value of the firm; $($b$)$ the value of debt and equity; and $($c$)$

the stock price under each option, if you assume rational stockholders?

e$.$ From a cost of capital standpoint, which of the three options would you pick, or

would you stay at your current capital structure?

f$.$ What role $($if any$)$ would the variability in XYZ$\text{'}$s income play in your decision?

g$.$ How would your analysis change $($if at all$)$ if the money under the three options listed

above were used to take new investments $($instead of repurchasing debt or equity$)?$

h$.$ What other considerations $($besides minimizing the cost of capital$)$ would you bring to

bear on your decision?

i$.$ Intuitively, why doesn't the higher rating in option $1$ translate into a lower cost of

capital?