Fin 370 Week 4 Individual Assignment Essay

291 WordsAug 7, 20122 Pages
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

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