Question

1. Capital structure decisions and firm value

Why focus on the optimal capital structure?

A company’s capital structure decisions address the ways a firm’s assets are financed (using debt, preferred stock, and common equity capital) and is often presented as a percentage of the type of financing used.

As with all financial decisions, a firm should try to establish a capital structure that maximizes the stock price, or shareholder value. This is called the optimal capital structure; it is also the debt-equity mix that:

maximizes the firm’s weighted average cost of capital.

minimizes the firm’s weighted average cost of capital.

maximizes the firm’s dividends.

maximizes the company’s net income.

Understanding the impact of debt in the capital structure

Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key issues related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have made some mistakes.

Review the list and identify which items are correct.

Workshop Talking Points Check all that apply.

The pre-tax cost of debt increases as a firm’s risk of bankruptcy increases.

Risks of bankruptcy increase management spending on perquisites and increase agency costs.

An increase in debt financing beyond a certain point is likely to increase the firm’s cost of equity.

An increase in the risk of bankruptcy is likely to reduce a firm’s free cash flows in the future.

An increase in debt financing decreases the risk of bankruptcy.

Answer 1

Answer 1 minimises the firm's weighted average cost of capital

The firm tries to achieve the optimal capital structure that is the debt equity mix which minimises the firm's total cost of capital

Answer 2

That correct choices are

1. The per tax cost of debt increases as a firm's risk of bankruptcy increases

2. An increase in debt financing beyond a certain point is likely to increase the firm's cost of equity as the total risk increases

3. An increase in the risk of bankruptcy is likely to reduce of forms free cash flows in the future because of higher cost of Financing.