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Cost of Capital and Pro Forma Balance Sheet

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?

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. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?
- Please view the attachment for the chart pertaining to part a.

WACC = Proportion of debt X after tax cost of debt + Proportion of equity X cost of equity
WACC = Debt/Assets X after tax cost of debt + (1-Debt/Assets) X cost of equity

b. Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with the firm's current ...

Solution Summary

This solution explains the calculation for the cost of capital for different capital structures and the preparation of a proforma balance sheet. A Word file is attached which contains the required chart for one part of this solution.

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