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# weighted-average cost of capital (WACC); pro forma balance

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A firm's current balance sheet is as follows:

Assets \$100 Debt \$10
Equity \$90

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 \$?

1. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
2. If a firm uses too much debt financing, why does the cost of capital rise?

#### Solution Preview

Balance Sheet for a Company
A firm's current balance sheet is as follows:
Assets \$100 Debt \$10
Equity \$90

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% 12%
10% 8% 12% 11.60%
20% 8% 12% 11.20%
30% 8% 13% 11.50%
40% 9% 14% 12%
50% 10% 15% 12.50%
60% 12% 16% 13.60%

cost of capita (k) = (weight) (cost of debt) + (weight) (cost of equity)

First, we need to know that ...

#### Solution Summary

This solution is comprised of a detailed explanation to compute the weighted-average cost of capital, compare the balance sheet with the firm's current balance sheet, answer what happens to the cost of capital, and why does the cost of capital rise if a firm uses too much debt financing.

\$2.19