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3. A firm’s current balance sheet is as follows:
Assets $100 Debt $10
Equity $90


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 $100 Debt$? $20
Equity$? $80

Debt/Assets Cost of Debt Cost of Equity Cost of Capital
0% 8% 12% 12.00%
10% 0.08 0.12 11.60%
20% 0.08 0.12 11.20%
30% 0.08 0.13 11.50%
40% 0.09 0.14 12.00%
50% 0.1 0.15 12.50%
60% 0.12 0.16 13.60%

C. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why.
As we add more cash the cost of capital decline as loan is cheaper than equity.

D. If a firm uses too much debt financing, why does the cost of capital rise?
If there is too much of debt, the again the cost of capital increase. As debt rises, the risk for banks increase as firm may not be able to reply the loan in time. Further the risk of shareholders increase as they may not be get any return if the profits are less than interest to be paid. At higher debt both the debt investor and equity holder demand higher return and hence cost of capital increase.