A Firm's Current Balance Sheet

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  • Topic: Finance, Cost of capital, Capital structure
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Problem 3

Accounting

Chapter 21 Problem 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%| 12.00%|
10%| 8%| 12%| 11.60%|
20%| 8%| 12%| 11.20%|
30%| 8%| 13%| 11.50%|
40%| 9%| 14%| 12.00%|
50%| 10%| 15%| 12.50%|
60%| 12%| 16%| 13.60%|

K=(weight*cost of debt)+( weight*cost of equity)
A. (0% x 8%) + (100% x 12%) = .120 or 12%
B. (0.10) x (0.08) + (0.90) x (0.12) = 0.116 or 11.6%
C. (0.2)(0.08) + (0.8)(0.12) = 0.112 or 11.2%
D. (0.3)(0.08) + (0.7)(0.13) = 0.115 or 11.5%
E. (0.4)(0.09) + (0.6)(0.14) = 0.120 or 12%
F. (0.5)(0.10) + (0.5)(0.15) = 0.125 or 12.5%
G. (0.6)(0.12) + (0.6)(0.16) = 0.136 or 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?

Current Balance Sheet

Assets| 100.00| Debts| 10.00|
| | Equity| 90.00|
Total Assets| 100.00| Total Debt and Equity| 100.00|

Performa Balance Sheet

Assets| 100.00| Debt| 20.00|
| | Equity| 80.00|
Total Assets| 100.00| Total Debt and Equity| 100.00|

Since the equity is $10.00 it should be brought back up and raise the liability by $10.00

C. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?

The cost of capital starts decreasing when a company substitutes debt for equity financing. The After-tax cost of debt is lower than the cost of equity = cost of debt is cheaper than the cost of capital

D. If a firm uses too much debt financing, why does the cost of capital rise? Bankruptcy increases as more debt is introduced to the...
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