Download A firm`s current balance sheet is as follows: Assets

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/
Assets
0%
10
20
30
40
50
60
Weight x + Weight x = Cost of
Cost
Cost
Capital
of Debt
of Equity
(.0)(.08) + (1.0)(.12) = .120
(.1)(.08) + (.9)(.12) = .116
(.2)(.08) + (.8)(.12) = .112
(.3)(.08) + (.7)(.13) = .115
(.4)(.09) + (.6)(.14) = .120
(.5)(.10) + (.5)(.15) = .125
(.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.