Bond Rating and Cost of Capital. Two bond rating agencies, Moody’s and Standard and Poor’s, lowered the ratings on Appleton Industries’ bonds from triple-A to double-A in response to operating trends...

Bond Rating and Cost of Capital. Two bond rating agencies, Moody’s and Standard and Poor’s, lowered the ratings on Appleton Industries’ bonds from triple-A to double-A in response to operating trends revealed by the financial reports of recent years. The change in the ratings is of considerable concern to the Appleton management because the company plans to seek a significant amount of external financing within the next 2 years.

                (a) Identify several events or circumstances which could have occurred in the operations of Appleton Industries that might have influenced the factors the bond rating agencies use to evaluate the firm and, as a result, caused the bond rating agencies to lower Appleton’s bond rating. (b) If Appleton Industries maintains its present capital structure, what effect will the lower bond ratings have on the company’s weighted average cost of capital? Explain your answer. (c) If Appleton Industries’ capital structure was at an optimal level before the rating of its bonds was changed, explain what effect the lower bond ratings will have on the company’s optimal capital structure. (CMA, adapted.)