Fin, 370 Chapter Sutdy Questions Week 5

Topics: Finance, Cost of capital, Investment Pages: 2 (303 words) Published: May 25, 2011
Resource: Basic Finance: An Introduction to Financial Institutions, Investments, and Management Prepare a response to Problem 3 (Ch. 21) of Basic Finance: An Introduction to Financial Institutions, Investments, and Management. Ch. 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 fallowing 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%|
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 $? Using the WACC at the minimum gives the optimal Capital Structure, which is 20% Debt. Assets| $100| Debt| $20|

| | Equity| $80|
Total Assets| $100| Total Debt & Equity| $100|

c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why? The cost of capital decreases due to the fact that the After-tax cost of debt is lower than costs of equity, causing cheaper debt to be substituted for more expensive equity lowering the cost of capital.  

d. If a firm uses too much debt financing, why does the cost of capital rise? When more debt is introduced to a capital structure, there is a risk of default and consequently bankruptcy.  As the risk increases, investors start requiring higher return on investments to compensate for the risk they are under, which increases the overall cost of capital. 
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