1. The after-tax cost of debt and the cost of equity for Company Z are as follows at various percentages of debt in its capital structure. (Note: the firm does not have any preferred stock, so the capital structure is comprised of only debt and common equity.) Calculate the firm's weighted average cost of capital at each combination of debt and equity:
Debt / Assets
After-Tax Cost of Debt
Cost of Equity
Weighted Average Cost of Capital
0%
5%
10%
10%
5%
10%
20%
5%
10%
30%
5%
11%
40%
7%
11%
50%
8%
12%
60%
9%
13%
2. Company Z's current balance sheet is as follows:
Assets
$100,000
Debt
$10,000
Equity
$90,000
Construct a pro forma balance sheet that indicates the firm's optimal capital structure, based on the results from Question 1. Compare this balance sheet with the firm's current balance sheet. What course of action should the firm take?
3. What is the company's cost of capital when the company has no debt?
4. What happens to the cost of capital when the company first assumes some debt?
5. What happens to the cost of capital as the level of debt increases?
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