Basic Finance: An Introduction to Financial Institutions, Investments, and Management by Mayo
Axia College of University of Phoenix (UoP)
FIN 370 Week 5 CLICK HERE FOR SOLUTION
Text Problem 3 A firm’s current balance sheet is as follows:
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? 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% ?
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?
