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Is the capital structure that maximizes the value of a firm consistent with the capital structure...

Is the capital structure that maximizes the value of a firm consistent with the capital structure that minimizes its WACC? Explain

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Answer #1

Yes, the above statement is true.

Cost of capital always has a mix of debt and equity. Cost of debt is always low because it is calculated post tax.

Having debt in the capital structure can optimize the value of a firm because of leveraging.

However debt is risky so having too much debt in the capital is not ideal.

Standard debt to equity ratio is 2:1. We may use this ratio to compare with other firms.

We calculate value of a firm by dividing future cash flows by WACC. Thus lower the WACC higher will be value of firm. For achieving a low WACC we need to have debt as source of finance.

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