Page 396 problem 3 located in Chapter 21 of the Basic Finance: An Introduction to Financial Institutions, Investments, and Management text by Mayo.
The cost of capital (k) is a weighted average:
k = (weight)(cost of debt) + weight(cost of equity)
A firm’s current balance sheet is as follows:
Assets $100 Debt $10
a. What is the firm’s weighted-average cost of capital at various combinations of debt and equity, given the following information:
Equity Debt/Assets After-Tax Cost of Debt
100.0% 0% 8%
90.0% 10% 8%
80.0% 20% 8%
70.0% 30% 8%
60.0% 40% 9%
50.0% 50% 10%
40.0% 60% 12%
b. Construct a pro forma balance sheet that indicates the firm’s optimal capitalstructure. Compare this balance sheet with the firm’s current balance sheet.
What course of action should the firm take?
c. When 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?