Problem: 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?