FIN370

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
Equity               $90

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?