3. A firm’s current balance sheet is as follows: Assets $100 Debt $10 Equity $90
ID: 2667855 • Letter: 3
Question
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?
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 $?
Equity $?
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?
Assets $100 Debt $10
Equity $90
Explanation / Answer
a) D/A = 0%, Cost of capital = 12% D/A = 10%, Cost of capital = (10%*8%)+(90%*12%)=11.6% D/A = 20%, Cost of capital = 11.2% D/A = 30%, Cost of capital = 11.5% D/A = 40%, Cost of capital = 12% D/A = 50%, Cost of capital = 12.5% D/A = 60%, Cost of capital = 13.6% b) Assets = 100 Debt = 20 Equity = 80 Compared to the current one, firm should borrow more (increase debt) and may buy back some shares to reduce equity c) Cost of capital decreases because firm can take advantage of cost of debt, which is lower than cost of equity d) When too much debt is used, firm can become very risky. As a result, cost of debt increases (lender expects higher return on lending because firm is more risky) and cost of equity also increases (equityholders demand higher return, as they will get paid after all debtholders.
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