1. A firm’s current balancesheet is as follows: Assets $100 Debt $10 Equity $90

ID: 2770681 • Letter: 1

Question

1. A firm’s current balancesheet is as follows:

Assets $100 Debt $10

Equity $90

a. What is the firm’s weighted-average cost of capital atvarious combinations of

debt and equity, given the following information?

Debt/Assets After-Tax Cost ofDebt 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 thefirm’s optimal capital

structure. Compare this balance sheet with the firm’scurrent 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 ofcapital rise?

1. A firm’s current balancesheet is as follows: Assets $100 Debt $10 Equity $90

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