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Substituting debt for equity

3. A firm's current balance sheet is as follows:
Assets $100 Debt $10 Equity $90

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 ?

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?

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c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?

As we can see in the table, the cost of capital decreases initially. The reason is that we are substituting lower cost debt with higher cost equity and so the cost of capital decreases. Initially when debt is at lo ...

Solution Summary

The solution explains the impact on the cost of capital of a firm as it substitutes debt for equity

$2.19