Question

Discuss the impact of corporate taxes on the optimal capital structure of the firm in an otherwise perfect capital market.

Answer 1

Optimal capital structure is a mix of debt and equity that maximize the firm's market value with minimum weighted average cost of capital according to modiglani Miller theory if there are no taxes then capital structure has no effect on firms weighted average cost of capital. But in a world of taxes interest payments will get tax sheild which will decrease cost of debt. Now increasing debt will increase the value of firm as it lowers the wacc. Now increasing too much debt will make equity holeders risk averse and will increase cost of equity. So debt must be raised to a point of extent which will maximize firms value we use debt equity ratio to analyse the optimal point