Now that the board members of Felicia & Fred are planning to implement a new crystal jewelry product line, they are concerned about potential shareholder sentiment regarding the dilution of ownership interest. As a result of this, the board is giving consideration to a significant change in capital structure in order to raise the cash required to fund the project. This would change the current capital structure from 30% debt and 70% equity to 70% debt and 30% equity.
Although shareholder sentiment may be appeased by this approach, discuss the following considerations that may emerge as a result of this drastic change in capital structure from a qualitative perspective:
Question 1
What is the likely effect on the weighted average cost of capital? Explain by example.
Question 2
What might be the impact on firm risk, and the perception of the firm’s credit rating? What signals could it send to the market?
Question 3
Some shareholders have also voiced concern that such a dramatic shift could bring financial distress to the firm. Under what conditions could this occur? And what are the potential costs to the firm as a result of it?