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 ofdebt Cost ofEquity 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 ofcapital rise?

Explanation / Answer

a) WACC, C = We*Ke + Wd*Kd(after tax) 1. C = 1*12+0*8 = 12% 2. C = 0.90*12+0.10*8 = 11.6% 3. C = 0.80*12+0.20*8 = 11.2% 4. C = 0.70*13+0.30*8 = 11.5% 5. C = 0.60*14+0.40*9 = 12.0% 6. C = 0.50*15+0.50*10 = 12.5% 7. C = 0.40*16+0.60*12 = 13.6% b) 1. Assets $100 Debt $0 Equity $100 2. Assets $100 Debt $10 Equity $90 3. Assets $100 Debt $20 Equity $80 4. Assets $100 Debt $30 Equity $70 5. Assets $100 Debt $40 Equity $60 6. Assets $100 Debt $50 Equity $50 7. Assets $100 Debt $60 Equity $40 c) As debt increases, WACC decrease for same Ke and Kd. d) When too much of debt is used, both Ke and Kd rise due to higher risk of leverage and WACC goes up fast.

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