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Cost of Capital Problem

Current Balance Sheet
Assets $100 Debt $10
Equity $90

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% ?

What is the firm's weighted-average cost of capital at various combinations of debt and
equity, given the above information?
cost of capita (k) = (weight) (cost of dept) + (weight) (cost of equity)
k = (0) .08 + (0) .12 = 0 IS THIS CORRECT

Construct a pro forma balance sheet that indicated the firms 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 $ ?

As a firm initially substitues debt for equity what happens to the cost of capital, and why?

If a firm uses too much debt financing, why does the cost of capital rise?

How would I go about this problem?

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Solution Preview

Current Balance Sheet
Assets $100 Debt $10
Equity $90

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%

What is the firm's weighted-average cost of capital at various combinations of debt and
equity, given the above information?

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

First, we need to know that ASSET = DEBT + EQUITY. Therefore, when Debt/Assets ...

Solution Summary

This solution is comprised of a detailed explanation to answer the request of the assignment in excel file.

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