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A firm's current balance sheet is as follows:
Assets $100Debt $10Equity $90
A. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?
Debt/Asset After 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 $100Debt?Equity?
C. As a firm initially substitutes debt for equity financing, what happen 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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