Problem 21-03

A firms current balance sheet is as follows:

Assets	$	150		Debt	$	30
				Equity	$	120

What is the firms 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	%	12	%	%
10		8		12		%
20		8		12		%
30		9		12		%
40		9		13		%
50		10		14		%
60		12		14		%

Construct a pro forma balance sheet that indicates the firms optimal capital structure. Choose the best structure from the options analyzed in part a. Compare this balance sheet with the firms 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 -Select-isis notItem 11 at its optimal capital structure and -Select-should not change the capital structure.should substitute some debt for equity.should substitute some equity for debt.Item 12

As a firm initially substitutes debt for equity financing, what happens to the cost of capital?

The cost of capital initially -Select-decreases.increases.does not change.Item 13

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 -Select-morelessItem 14 financially leveraged and riskier. This causes the interest rate to -Select-risefallItem 15 and the cost of equity to -Select-increasedecreaseItem 16 . These changes in the cost of debt and equity cause the cost of capital to -Select-increasedecreaseItem 17 .