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# Capital Structure, Cost of Capital

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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?

#### Solution Preview

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% 12.00% =0.%x1200.%+(100% - 0.%) x12.%
10% 8% 12% 11.60% =10.%x1200.%+(100% - 10.%) x12.%
20% 8% 12% 11.20% =20.%x1200.%+(100% - 20.%) ...

#### Solution Summary

Answers to questions on Capital Structure, Cost of Capital. It calculates a firm's weighted-average cost of capital at various combinations of debt and equity. It constructs a pro forma balance sheet that indicates the firm's optimal capital structure. It provides answers to what happens to the cost of capital when the firm initially substitutes debt for equity financing and why the cost of capital rises if a firm uses too much debt financing.

\$2.19