A firm's current balance sheet is as follows:



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 Cap

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?

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?

a)

|Debt/Assets |After-tax Cost of Debt |Cost of Equity |Cost of Capital |

|0% |8% |12% |12.00% |

|10% |8% |12% |11.60% |

|20% |8% |12% |11.20% |

|30% |8% |13% |11.50% |

|40% |9% |14% |12.00% |

|50% |10% |15% |12.50% |

|60% |12% |16% |13.60% |

b)

The optimal Capital Structure is where WACC is at the minimum, which is at 20% Debt.

|Performa Balance Sheet |

|Assets |$100 |Debt |$20 |

|  |  |Equity |$80 |

|Total Assets |$100 |Total Debt & Equity |$100 |

c)

As a firm initially substitutes debt for equity financing, the cost of capital starts decreasing. This is because the After-tax cost of debt is lower than the cost of equity, therefore when cheap debt is being substituted for the more expensive equity, the cost of capital decreases.

d)

As more debt is introduced to the capital structure of the firm, risk of default and consequently bankruptcy increases. As the risk increases, investors would start requiring a higher return on their investment so as to be compensated for the risk they are undertaking, which would increase the overall cost of capital.

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