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Fin 370 Week 4 Individual Assignment Essay

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Week 5 Problem 3
Carri Gradisca
FIN/370 – Finance for Business
August 6, 2012
Professor Shadi Sifain





Week 5 Problem 3
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% | 12.00% |
10 | 8 | 12 | 11.60% |
20 | 8 | 12 | 11.20% |
30 | 8 | 13 | 11.50% |
40 | 9 | 14 | 12.00% |
50 | 10 | 15 | 12.50% |
60 | 12 | 16 | 13.60% |

  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?
Current Balance Sheet:
Assets: $100
Debt: $10
Equity: $90
Optimal Balance Sheet:
Assets: $100
Debt: $20
Equity: $80
  c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
When a firm substitutes debt for equity financing the cost of capital will initially decrease because the effective cost of debt is less than the growth of the cost of equity.
  d. If a firm uses too much debt financing, why does the cost of capital rise?
If a firm uses the more and more debt for financing, the cost of capital will increase. This increase in the use of debt causes the interest rate to rise and the cost of equity to increase. This then causes the cost of capital to increase, thus becoming riskier.

References
Mayo, H. B. (2012). Basic finance: An...

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