Question 3:

A. Falcon Plastics Inc. has a capital structure consisting of 25% debt and 75% equity. Falcons debt currently has a 7% yield to maturity. The risk-free rate is 6%, and the market return is 13%. Using the CAPM, Falcons CFO estimates the cost of equity to be 14.5%. The company has a 25% tax rate. Address the following:

1. What is Falcons current WACC?

2. What is the current beta on Falcons common stock?

3. What would Falcons beta be if the company had no debt in its capital structure?

4. If any, what is the difference between the beta values in questions 2 and 3?

B. Falcons financial staff considers changing its capital structure to 40% debt and 60% equity. If the company went ahead with the proposed change, the yield to maturity on the companys bonds would rise to 10.5%. The proposed change will not affect the companys tax rate.

5. What would be the companys new cost of equity if it adopted the proposed change in the capital structure?

6. What would be the companys new WACC if it adopted the proposed change in the capital structure?

7. Based on your analyses to question 6, would you advise Falcons board to adopt the proposed change in the capital structure? Explain.