Fin 370 Week 5

Topics: Cost of capital, Finance, Asset Pages: 2 (262 words) Published: January 14, 2013
A firm’s current balance sheet is as follows:

Assets \$100 ,Debt \$100, 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% x8%= 0 1 x12%=12

10% x 8%=.890 x12%=10.8 =11.6

20% x8%=1.680 x12%=9.6=11.2

30% x 8%=2.470 x13%=9.1=11.5

40% x9%=3.660 x14%=8.4=12

50% x10%=550 x15%=7.5=12.5

60% x12%=7.240 x16%=6.4=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 raise liability \$10

C. As a firm initially substitutes debt for equity financing, what happens to the cost of capital , and why? Cost of capital will go down as cost of debt is cheaper than cost of equity.

D. If a firm uses too much financing , why does the cost of capital rise? Debt is cheaper than equity. Equity will increase the cost of capital.