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A fir a firm's current balance sheet is as follows: Assets $100 Debt $10 Equity $90 1.

1. A fir a firm's current balance sheet is as follows:
Assets $100 Debt $10
  Equity $90
1. 1.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 ?
2. 2. 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 $?
3. 3. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why?
4.
5. 4. If a firm uses too much debt financing, why does the cost of capital rise?

This question was asked on Mar 17, 2010.

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