Afirm\'s current balance sheet is as follows: Assets $100 Debt $10 Equity $90 Wh

Question

Afirm's current balance sheet is as follows:

Assets $100 Debt $10
Equity $90

What is the firm's weighted-average cost of capital at various combinations of debt and equity,given the following information?

After-Tax Cost of Cost of Cost of Capital
Equity
Debt/Assets Debt
0% 8% 12% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?

Construct a pro forma sheet that indicates the firm's optima capital structure.Compare this balance sheet.What course of action should the firm take?

Assets $100 Debt $?
Equity $?

As a firm initially substitutes debt for equity financing, what happens to the cost of capital,and why?
If a firm uses too much debt financing,why does the cost of the capital rise?

Explanation / Answer

WACC is 0% 12.0 10% .10*8 +.9*12= 11.6 20% .2*8 +.8 *12=11.2 30% .3*8 +.7*13= 11.5 40% .4*9 +.6*14= 12.0 50% .5*10 +.5*15= 12.5 60% .6*12 + .4*16= 13.6 Assets 100 Debt 20 Equity 80 minimizes the WACC. Firm should take on more debt (10). As firm initially takes on debt WACC goes down because debt is cheaper than equity (interest is tax deductible, and debt (a relatively small amount) is seen as less risky than equity). However, if a large amount of debt is taken on than the risk profile of the company increases due to the threat of bankruptcy if the company is unable to service the debt and the WACC goes up.

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