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WACC and optimal capital structure

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?
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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?

Solution Summary

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

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