<p> 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? </p><p>Debt/Assets After-Tax Cost of Debt Cost of Equity Cost of Cap </p><p>0% 8% 12% ? 10 8 12 ? 20 8 12 ? 30 8 13 ? 40 9 14 ? 50 10 15 ? 60 12 16 ? </p><p> 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? </p><p> c. As a firm initially substitutes debt for equity financing, what happens to the cost of capital, and why? </p><p> d. If a firm uses too much debt financing, why does the cost of capital rise? </p><p> a) </p><p>After-tax Cost of Cost of Cost of Debt/Assets Debt Equity Capital 0% 8% 12% 12.00% 10% 8% 12% 11.60% 20% 8% 12% 11.20% 30% 8% 13% 11.50% 40% 9% 14% 12.00% 50% 10% 15% 12.50% 60% 12% 16% 13.60%</p><p> b) </p><p>The optimal Capital Structure is where WACC is at the minimum, which is at 20% Debt.</p><p>Performa Balance Sheet Assets $100 Debt $20 Equity $80 Total Assets $100 Total Debt & Equity $100 </p><p> c) </p><p>As a firm initially substitutes debt for equity financing, the cost of capital starts decreasing. This is because the After-tax cost of debt is lower than the cost of equity, therefore when cheap debt is being substituted for the more expensive equity, the cost of capital decreases.</p><p> d) </p><p>As more debt is introduced to the capital structure of the firm, risk of default and consequently bankruptcy increases. As the risk increases, investors would start requiring a higher return on their investment so as to be compensated for the risk they are undertaking, which would increase the overall cost of capital.</p>