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/Asset After 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 happen to the cost of capital, and why?

D. If a firm uses too much debt financing, why does the cost of capital rise?