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    WACC and optimal capital structure

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    Individual Assignment Problem 3 Chapter 21 - Basic Finance by Herbert Mayo

    A. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?

    B. Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with 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?
    _________________________________________________________________________
    3. 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 ?

    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?

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    Solution Summary

    The solution explains how to find the optimal capital structure using the WACC and then to prepare a pro-forma balance sheet.

    $2.19

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