Week 5 - Problem 3 (Ch.
21) Text Questions (Individual Assignment)
FIN370 - 3.
A firm's current balance sheet is as follows:
Page 396 problem 3 located in Chapter 21 of
the Basic Finance: An Introduction to Financial Institutions, Investments,
and Management text by Mayo.
The cost of capital (k) is a
weighted average:
k = (weight)(cost of debt) +
weight(cost of equity)
3. A firm's current balance sheet is
as follows:
|
Assets
|
$100
|
Debt
|
$10
|
|
Equity
|
$90
|
a. What is the firm's
weighted-average cost of capital at various combinations of debt and equity,
given the following information:
|
Equity
|
Debt/Assets
|
After-Tax
Cost of Debt
|
Cost of
Equity
|
Cost of
Capital
|
|
100.0%
|
0%
|
8%
|
12%
|
|
|
90.0%
|
10%
|
8%
|
12%
|
|
|
80.0%
|
20%
|
8%
|
12%
|
|
|
70.0%
|
30%
|
8%
|
13%
|
|
|
60.0%
|
40%
|
9%
|
14%
|
|
|
50.0%
|
50%
|
10%
|
15%
|
|
|
40.0%
|
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?
c. When 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?
File name:
3.-A-firms-current-balance-sheet-is-as-follows-temp.xls File type:
application/vnd.ms-excel Price: $5
