A firm’s current balance sheet is as follows: Assets $ 150 Debt $ 30 Equity $ 120 What is the firm’s weighted-average cost of capital at various combinations of debt and equity, given the following information? Round your answers to one decimal place. Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of Capital 0 % 8 % 15 % % 10 8 15 % 20 9 15 % 30 9 15 % 40 11 16 % 50 13 16 % 60 15 18 % Construct a pro forma balance sheet that indicates the firm’s optimal capital structure. Choose the best structure from the options analyzed in part a. Compare this balance sheet with the firm’s current balance sheet. Round your answers to the nearest dollar. Assets $ 150 Debt $ Equity $ What course of action should the firm take? Round your answer to the nearest whole number. Since the firm is currently using % debt financing, it at its optimal capital structure and As a firm initially substitutes debt for equity financing, what happens to the cost of capital? The cost of capital initially If a firm uses too much debt financing, why does the cost of capital rise? If a firm uses too much debt financing, the firm becomes financially leveraged and riskier. This causes the interest rate to and the cost of equity to . These changes in the cost of debt and equity cause the cost of capital to .
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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Problem 21-03 A firm’s current balance sheet is as follows:
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