a.Given the following schedules, ? debt/assets cost of cost of debt equity 0% 7% 14% 10 7 14 20 7 14 30 8 14 40 8 16 50 10 18 60 12 20 ? what is firm's cost of capital at the various combinations of debt and equity? b. What is the firm's optimal capital structure? Construct a balance sheet showing that

Question

combination of debt and equity financing. ?      Balance Sheet for Firm X as of XX/XX/XX        Assets      $100        Debt                                      Equity                                                            $100  c. If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their required rate of return if the firm uses its optimal combination of debt and equity financing? d. If the above cost of equity is the cost of retained earnings, what happens to the cost of capital if the cost of new shares is one percentage pointhigher at the firm's optimal capital structure? e. If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital structure if the firm needs $2,000,000?

What will be an ideal response?

Answer 1

a. Determination of cost of capital:?     k = weight X cost of debt + weight X cost of equity         = .0(.07) +  1(.14) = 14.00%        = .1(.07) + .9(.14) = 13.30        = .2(.07) + .8(.14) = 12.60        = .3(.08) + .7(.14) = 12.20        = .4(.08) + .6(.16) = 12.80        = .5(.10) + .5(.18) = 14.00           =.6(.12) + .4(.20) = 15.20b. The optimal capital structure is 30% debt and 70% equity.The balance sheet is?     Balance Sheet for Firm X as of XX/XX/XX     Assets         $100         Liabilities    $30                                        Equity           70                                                         $100c. If the firm earns $10 on every $100 of assets (i.e., 10% on assets), the stockholders will not receive their required return of 14%. With 30% debt financing, $2.40 must go to creditors ($30 x .08 = $2.40), which leaves $7.60 for stockholders ($10 ? 2.40). Since the stockholders have invested $70, they earn a return of 10.86% ($7.60/$70).?For the stockholders to earn their required return, the firm must earn at 12.2%. Then the firm can pay the creditors $2.40 and have sufficient left over ($9.80) so that the stockholders earn the 14% required rate of return (i.e., $9.80/$70 = 14%).
d. If the cost of new equity rises to 15 percent, the cost of capital at the optimal capital structure becomes:      .3(.08) + .7(.15) = 12.90.e. If the firm has retained earnings of $1,500,000, the breakpoint in the marginal cost of capital schedule is     $1,500,000/.7 = $2,142,857.?The cost of capital from $0 - $2,142,857 is 12.2%.The cost of capital above $2,142,857 is 12.9%.?The cost of $2,000,000 is 12.2 percent. The cost of the next $2,000,000 is $142,857 at 12.2 percent and $1,857,143 at 12.7 percent.