Problem: A firm's current balance sheet is as follows:
Assets $100
Debt $10
Equity $90
a. What is the firm weighted average cost of capital and 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?