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# Optimal capital structure

Answer questions of parts a & b of attached worksheet.

A firm's current balance sheet is as follows:

Assets 100 Debt 10
Equity 90

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 Score Weight x Cost of Debt Weight x Cost of Equity Total Cost of Capital
0% 8% 12% 12.00% 0.25 0% 12% 12.0%
10% 8% 12% 11.60% 0.25 1% 11% 11.6%
20% 8% 12% 11.20% 0.25 2% 10% 11.2% <==Minimum Cost of Capital
30% 8% 13% 11.50% 0.25 2% 9% 11.5%
40% 9% 14% 12.00% 0.25 4% 8% 12.0%
50% 10% 15% 12.50% 0.25 5% 8% 12.5%
60% 12% 16% 13.60% 0.25 7% 6% 13.6%

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 20 0.25 Assets 100 Debt 20
Equity 80 0.25 Equity 80
100 100

#### Solution Summary

The solution explains how to select the optimal capital structure and make necessary changes in the balance sheet

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