A firm’s current balance sheet is
as follows:
Assets $100 Debt $10
Preferred
stock $90
a. What is the firms
weighted-average cost of capital at various combinations of debt and equity,
given the following information?
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 ?
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 $?
Preferred
stock $?
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?
TUTORIAL PREVIEW
WACC = W d * K d + W e * K e
Debt/Assets
|
Wd
|
After-Tax Cost of Debt
|
We
|
Cost of Equity
|
Cost of Capital
| |
0%
|
0
|
8%
|
1
|
12%
|
0.12
|
= 12%
|
10%
|
0.1
|
8%
|
0.9
|
12%
|
0.116
|
= 11.6%
|
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