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?

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?

. 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 ?

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?

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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