A firm's current balance sheet is as follows:
Assets $100, Debt $10, Equity $90
Q1. 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 ?
Q2. 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?
Q3. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
Q4. If a firm uses too much debt financing, why does the cost of capital rise?