Wk 5 Fin 370 Assignment from Reading

A firm’s current balance sheet is as follows:
Assets $100 Debt $10 Equity $90
What is the firm’s weighted-average cost of capital at various combinations of debt and equity; given the following information? Show work
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% ?

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%
20% 0.2 8% 0.8 12% 0.112 =11.2%
30% 0.3 8% 0.7 13% 0.115 =11.5%
40% 0.4 9% 0.6 14% 0.12 = 12%
50% 0.5 10% 0.5 15% 0.125 =12.5%
60% 0.6 12% 0.4 16% 0.136 = 13.6%

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 $?
Balance Sheet at Optimal Capital Structure
Asset 100 Liabilities 20 Equity 80
Total 100 100

Current Balance Sheet
Asset 100 Liabilities 10 Equity 90
Total 100 100

Equity of $10 should be bought back or reacquired by raising a liability of $10.
c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
Initially when the firm substitutes debt for equity financing the overall cost of capital will reduce as cost of debt is cheaper than cost equity.

d. If a firm uses too much debt financing, why does the cost of capital rise?
Employing debt in the business increases the risk of the firm. In such a case though initially debt proves to be cheaper than equity it will ultimately increase the overall cost of capital as