Solution) A firm's current balance sheet is as follows: Assets $100 Debt $10
Question: 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?
Solution:
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Deliverables: Word Document
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