A firm\'s current balance sheet is as follows: Assets $100 Debt $10 Equity $90 a
ID: 2662501 • Letter: A
Question
A firm's current balance sheet is as follows:Assets $100
Debt $10
Equity $90
a. What is the firm's weighted-average cost of capital at variouscombinations of debt and
equity, given the following information?
Debt/Assets After-Tax Cost ofDebt Cost ofEquity Cost of Capital
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?
b. Construct a pro forma balance sheet that indicates the firm'soptimal capital structure.
Compare this balance sheet with the firm's current balance sheet.What course of action
should the firm take?
Assets $100
Debt $?
Equity $?
c. As a firm initially substitutes debt for equity financing, whathappens to the cost of capital,
and why?
d. If a firm uses too much debt financing, why does the cost ofcapital rise?
Explanation / Answer
Debt/Assets
Wd
After-Tax Cost of Debt
We
Cost of Equity
Cost of Capital
0%
0
8%
1
12%
0.12
= 12%
10%
0.1
8%
0.9
12%
0.116
= 11.6%
20%
0.2
8%
0.8
12%
0.112
=11.2%
30%
0.3
Debt/Assets
Wd
After-Tax Cost of Debt
We
Cost of Equity
Cost of Capital
0%
0
8%
1
12%
0.12
= 12%
10%
0.1
8%
0.9
12%
0.116
= 11.6%
20%
0.2
8%
0.8
12%
0.112
=11.2%
30%
0.3
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