Hello Expert! I am at the last week of my class and I do not feel these kind of

Question

Hello Expert!

I am at the last week of my class and I do not feel these kind of problems have been explained well enough for me to understand them. I am in a crunch of course as it is due tomorrow. Would you be able to help me out on this one? I appreciate any help you can offer.

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 various combinations of
debt and equity, given the following information?

Debt/Assets After-Tax Cost of Debt Cost of Equity 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’s optimal 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, what happens to the cost of capital, and why?


D. If a firm uses too much debt financing, why does the cost of capital rise?

Explanation / Answer

Debt/Assets             After-Tax Cost of Debt Cost of Equity Cost of Capital

0% 8%                   12% ------------- 12.00%

10    8                      12 -------------------11.60%

20 8              12 --------------11.20%

30    8                    13 -----------------11.50%

40                       9                    14 ------------12.00%

50                                  10                  1 5 ------------12.50%

60 12                         16 -----------13.60%

B. Construct a pro forma balance sheet that indicates the firm’s optimal capital
structure. Compare this balance sheet with the firm’s current balance sheet.
What course of action should the firm take?

Assets $100    Debt $ 20
                                     Equity $80

--------------------------------------------

    100                                     100

C. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?

because above activity , the cost of capital start -decreasing

so after tax cost of debt is lower than cost of equity

D. If a firm uses too much debt financing, why does the cost of capital rise?

the risk of default and bankruptcy -------will increase

as risk increase -investor -rquire more returen

so increase in oveall capital cost

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.