Expert Answers

A firm’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?  Show work

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?