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WACC and optimal capital structure

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Individual Assignment Problem 3 Chapter 21 - Basic Finance by Herbert Mayo

A. What is the firm's weighted-average cost of capital at various combinations of debt and equity, given the following information?

B. Construct a pro forma balance sheet that indicates the firm's optimal capital structure. Compare this balance sheet with firm's current balance sheet. What course of action should the firm take?
C. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
_________________________________________________________________________
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% ?
10 8 12 ?
20 8 12 ?
30 8 13 ?
40 9 14 ?
50 10 15 ?
60 12 16 ?

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?
d. If a firm uses too much debt financing, why does the cost of capital rise?

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Solution Summary

The solution explains how to find the optimal capital structure using the WACC and then to prepare a pro-forma balance sheet.

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