Lecture 37 - Business Finance (ACC501) Lesson 37 Review of...

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190 Business Finance (ACC501) Lesson 37 Review of the Previous Lecture Cost of Capital Cost of Equity Cost of Debt Cost of Preferred Stock Capital Structure Weights The Tax Effect Weighted Average Cost of Capital (WACC) Topics Under Discussion Capital Structure Financial Leverage Homemade Leverage Unlevering Capital Structure The guiding principle in choosing the debt-equity ratio, is again to choose a course of action that maximizes the value of a share of stock. When it comes to capital structure decisions, this is the same thing as maximizing the value of the whole firm. Recall, WACC tells us that the firm’s overall cost of capital is the weighted average of the costs of various components of the firm’s capital structure. Usually, while describing WACC, we take the capital structure of the firm as given. But what happens to the cost of capital when we vary the amount of debt financing, or Debt-equity ratio? Recall that the WACC is the discount rate appropriate for the firm’s overall cash flows. Since the values and discount rates move in the opposite directions, we can say that the value of the firm’s cash flows (or the value of the firm) is maximized when the WACC is minimized. So we can safely say that one capital structure is better than the other if it results in a lower weighted average cost of capital Further, a particular debt-equity ratio represents the optimal capital structure if it results in the lowest possible WACC. This optimal capital structure is also called firm’s target capital structure.
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191 Financial Leverage Financial leverage refers to the extent to which a firm relies on the debt. The more debt financing a firm uses in capital structure, the more financial leverage it employs. Financial leverage can dramatically alter the payoffs to the shareholders in the firm,
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This note was uploaded on 08/04/2011 for the course ACCT 501 taught by Professor Na during the Spring '11 term at Virtual University of Pakistan.

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Lecture 37 - Business Finance (ACC501) Lesson 37 Review of...

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