Question 3:

A. Falcon Plastics Inc. has a capital structure consisting of 20% debt and 80% equity. Falcon's

debt currently has a 7% yield to maturity. The risk-free rate is 6%, and the market return is 16%.

Using the CAPM, Falcon's CFO estimates the cost of equity to be 14.5%. The company has a

20% tax rate. Address the following:

1. What is Falcon's current WACC?

2. What is the current beta on Falcon's common stock?

3. What would Falcon's 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. Falcon's 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

company's bonds would rise to 10.5%. The proposed change will not affect the company's tax

rate.

5. What would be the company's new cost of equity if it adopted the proposed change in the

capital structure?

6. What would be the company's new WACC if it adopted the proposed change in the

capital structure?

7. Based on your analyses to question 6, would you advise Falcon's board to adopt the

proposed change in the capital structure? Explain.