Computation of weighted average cost of capital
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%
|
?
|
|
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?
If a firm uses too much debt financing, why does the cost of capital rise