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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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Solution Summary

The weighted-average cost of capital is assessed.