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Balance Sheets and Weighted Average Cost of Capital

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A firm's current balance sheet is as follows:

Assets $100 Debt $10

Ã? Ã? 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/ After-Tax Cost of Equity Cost of
Assets Cost of Debt Equity 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 $?

Ã? Ã? 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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The weighted-average cost of capital is assessed.

$2.19
See Also This Related BrainMass Solution

Performa Balance Sheet - Weighted Average Cost of Capital

Weighted Average Cost of Capital

1. The after-tax cost of debt and the cost of equity as follows for a firm at various percentages of debt in its capital structure. Calculate the firm's weighted average cost of capital at each combination of debt and equity:

Debt / Assets After-Tax Cost of Debt Cost of Equity Weighted Average Cost of Capital
0% 6% 10% ?
10% 6% 10% ?
20% 7% 10% ?
30% 8% 11% ?
40% 9% 13% ?
50% 10% 14% ?
60% 12% 16% ?

2. A firm's current balance sheet is as follows:

Assets $100,000 Debt $10,000
Equity $90,000

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?

3. Explain what happens to a firm's weighted average cost of capital when there is no debt, when they first introduce some debt into the capital structure, and as the firm continues to increase the percentage of debt in the capital structure.

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