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    WACC in Various Combinations of Debt and Equity

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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 ?

    (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?

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    Solution Summary

    The solution explains how to calculate the WACC in various combinations of debt and equity and the reason for the change in WACC.