Review the information in the table below for Xenon Corporation. This informatio
ID: 2648753 • Letter: R
Question
Review the information in the table below for Xenon Corporation. This information was prepared by an investment bank to estimate how changing the capital structure of Xenon would impact various metrics. Answer the following questions. What is the optimal capital structure for Xenon? Why is this optimal? Why does the cost of debt increase as more debt financing is used? Why does the WACC decease and then increase and Value per share increase and then decrease as the capital structure changes?
Debt Financing
Equity Financing
Cost of Debt
Earnings per Share
Return on Equity
WACC
Value per Share
0%
100%
3.0%
$2.00
10%
11.0%
$35.00
10%
90%
3.5%
$2.20
12%
10.0%
$38.50
20%
80%
4.2%
$2.50
15%
9.0%
$41.25
30%
70%
4.7%
$2.75
17%
8.5%
$43.00
40%
60%
5.3%
$3.00
19%
9.2%
$40.00
50%
50%
6.0%
$3.30
22%
10.5%
$37.00
Debt Financing
Equity Financing
Cost of Debt
Earnings per Share
Return on Equity
WACC
Value per Share
0%
100%
3.0%
$2.00
10%
11.0%
$35.00
10%
90%
3.5%
$2.20
12%
10.0%
$38.50
20%
80%
4.2%
$2.50
15%
9.0%
$41.25
30%
70%
4.7%
$2.75
17%
8.5%
$43.00
40%
60%
5.3%
$3.00
19%
9.2%
$40.00
50%
50%
6.0%
$3.30
22%
10.5%
$37.00
Explanation / Answer
Answer 1
The most optimal structure is when the cost of capital is minimum and at which the firm maximize its value. In our case at 30% debt and 70% equity financing, the cost of capital is minimum and the value per share is $43 which is maximum.
Answer 2
With every increase in debt there is increase in interest payment which is charge or issuing the additional debt due to which the cost of debt increases. Due to increase in interest payment the cash flow also needs to increase so that it can cover the additional interest payments. Financer of debt capital become unsecured as due to increased debt they get worried about if the company will be able to meet its debt obligations or not. Equity share holder become unsecured because as the company's interest expense increase the Earning per share of decreases and as the equity share holder are paid in last at the time of insolvency they become worried about their investments.
Answer 3
WACC decreases and then increases because as the in the initial phase as the debt is increased and it is the low cost capital and the equity decrease because of the high cost it decreases the overall cost of capital. But as the debt is increased the cost of debt also increases due to which the overall cost of capital also increases, which lead to increase in WACC.
The value per share increases as in the initial phase the company had 100% equity financing, and zero% debt financing, debt financer provided the fund at lower value and it increased the earning per share due to which the value of the firm increased. But as and when more debt capital is added financer of debt capital become unsecured as due to increased debt they get worried about if the company will be able to meet its debt obligations or not due to which value of the firm started falling.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.