A firm’s current balance sheet i

| September 28, 2018

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?

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