Question

Why is firm value maximised somewhere between 0% and 100% debt?

Answer 1

Solution:

A firm generally has two types of capital- Equity and debt. The cost of equity is generally higher than the cost of debt. There is an optimum capital structure that exists for any company that maximizes the firm value and minimizes the weighted average cost of capital.

The debt ratio of 0% means the firm is using only equity and debt ratio of 100% means that the firm is using 100% debt. A higher debt ratio increases the cost of bankruptcy for the firm. Hence there will be an optimum capital structure that will be between 0 to 100% debt.