A firm\'s current balance sheet is as follows: Assets $100 Debt $10 Equity $90 (

Question

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 variouscombinations of debt and equity, given the followinginformation?

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'soptimal capital structure. Compare this balance sheet withthe firm's current balance.

Assets $100      Debt $?     Equity $?

(c) As a firm initially substitutes debt for equity financing, whathappens to the cost of capital, and why?

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

I'd like to know how you came up with the answer.  I am  not understanding the equations in the book.  Thanks!

Explanation / Answer

Hi,

Please find the answer as follows:

Part A:

Cost of Capital = Weight of Debt*After Tax Cost of Debt + Weight of Equity*Cost of Equity

Here Weight of Debt will be taken from Debt/Assets Column and Weight of Equity will be taken for each row as 1-Weight of Debt

Using above mentioned equation we will get:

For Example = 0*8% + (1-0)*12% = .120

Part B:

Proforma Balance Sheet:

From the above balance sheet, it can be studied that the firm is using 10% of debt in its overall capital structure and hence it is not at having an appropriate capital structure. The firm should include some equity in its capital structure to operate at the optimal level.

Part C:

Cost of capital will initially decline because the cost of equity is higher than the overall effective cost of debt.

Part D:

Inclusion of more and more debt in the capital structure makes the firm more financially leveraged. Further, higher proportion of debt increases the risk resulting in an increase in the interest rate and cost of equity. Increase in cost of debt and cost of equity consequently results in an increase in the weighted average cost of capital.

Thanks.

Debt/Assets Cost of Debt Cost of Equity Cost of Capital 0 8 12 0.120 10 8 12 0.116 20 8 12 0.112 30 8 13 0.115 40 9 14 0.120 50 10 15 0.125 60 12 16 0.136

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