A firm’s current balance sheet is as follows:
Assets $100 Debt $10
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 $?
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?