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

Option 1: Issue $1 billion in new stock and repurchase half of its outstanding debt. This will make it a AAA rated firm (AAA rated debt is yielding 11% in the market place).

Option 2: Issue $1 billion in new debt and buy back stock. This will drop its rating to A-. (A- rated debt is yielding 13% in the market place).

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 market place).

I. What is the cost of equity under each option?

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

III. What is the cost of capital under each option?

IV. 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?

V. From a cost of capital standpoint, which of the three options would you pick, or would you stay at your current capital structure?

VI. What role (if any) would the variability in XYZ's income play in your decision?

VII. 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)?

VIII. What other considerations (besides minimizing the cost of capital) would you bring to bear on your decision?

IX. Intuitively, why doesn't the higher rating in option 1 translate into a lower cost of capital?