International Finance
Karen Davis
University of Phoenix
September 9, 2010

Introduction
3. A firm’s current balance sheet is as follows: Assets - $100 Debt $10 Equity $90

Question 3a. What is the firm’s weighted cost of capital at various combinations of debt and equity, given the following information?
Debts/Assets After Tax Debt Cost Cost of Equity Cost of Capital (weight)(cost of debt) weight (cost of equity) = k (cost of capital) 0% 8% 12% 10 8 12% 20 8 12% 30 8 13% 40 9 14% 50 10 15% 60 12 16%

Answer –

Debts/Assets After Tax Debt Cost Cost of Equity Cost of Capital (weight)(cost of debt) weight (cost of equity) = k (cost of capital) 0% (.0)(.08) (1.0)(.12) 12.0 % 10% (.1)(.08) (.9)(.12) 11.6 % 20% (.2)(.08) (.8)(.12) 11.2% 30% (.3)(.08) (.7)(.13) 11.5% 40% (.4)(.09) (.6)(.14) 12.0% 50% (.5)(.10) (.5)(.15) 12.5% 60% (.6)(.12) (.4)(.16) 13.6%

Question 3b. 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?
CURRENT BALANCE SHEET PROFORMA BALANCE SHEET Assets - $100 Assets - $100 Debt $10 Debt $20 Equity $90 Equity $80

The optimal capital structure is “the unique capital structure that minimizes the firm’s composite cost of long-term capital” (Keown, et.al. 2005). The debt is 20% of the capital and the cost of capital is 11.2%, as shown, highlighted, on the Performa balance sheet (#3a) above. In this case, since only 10% debt financing is being used, the firm should substitute some more debt in place of equity.
Question 3c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why? As a firm initially substitutes debt financing for equity financing, the cost of