A firm’s current balance sheet is as follows: Assets $100 ...
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 Asset After tax cost of debet Cost of equity Cost of Capital 0% 8% 12% ? 10% 8% 12% ? 20% 8% 12% ? 30% 8% 13% ? 40% 8% 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?
The cost of capital (k) is a weighted average:
k = (weight)(cost of debt) + weight(cost of equity)
Debt/ Weight x + Weight x = Cost of
Assets Cost Cost Capital
of Debt of Equity
0% (.0)(.08) + (1.0)(.12) = .120
10 (.1)(.08) + (.9)(.12) = .116
20 (.2)(.08) + (.8)(.12) = .112
30 (.3)(.08) + (.7)(.13) = .115
40 (.4)(.09) + (.6)(.14) = .120
50 (.5)(.10) + (.5)(.15) = .125
60 (.6)(.12) + (.4)(.16) = .136
b. The optimal capital structure is that combination, which minimizes the firm's cost of capital. In this case that occurs where debt is 20% of capital and the cost of capital is 11.2%. The balance sheet is
Assets $100 Liabilities $20
Equity 80
Since the firm is currently using only 10% debt financing, it is not at its optimal capital structure and should substitute some debt for equity.
c. The cost of capital initially declines because the effective cost of debt is less than the cost of equity.
d. As the firm continues to substitute debt for equity, the firm becomes more financially leveraged and riskier. This causes the interest rate to rise and the cost of equity to increase. These increases in the cost of debt and equity cause the cost of capital (i.e., the weighted average) to increase.
................
................
In order to avoid copyright disputes, this page is only a partial summary.
To fulfill the demand for quickly locating and searching documents.
It is intelligent file search solution for home and business.
Related download
- chapter 15 capital structure basic concepts
- distributed hydrogen production via steam methane reforming
- chapter 7 net present value and capital budgeting
- the cost of capital reflects the cost of funds
- 1 cpa diary
- part ii the cost of capital exinfm
- multiple choice questions
- chapter 13 the cost of capital
- a firm s current balance sheet is as follows assets 100
- guidelines to determine asset impairment and reporting of
Related searches
- balance sheet of a publicly traded company
- reading a balance sheet 101
- current balance sheet for amazon
- what is a balance sheet for business
- preparing a balance sheet accounting
- amazon s balance sheet official
- balance sheet current assets
- current balance sheet sample
- current balance sheet template
- balance sheet assets list
- balance sheet for a business
- a balance sheet lists