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Unformatted text preview: hat EBIT is constant, the value of the firm, V, is maximized
by minimizing the weighted average cost of capital, ka. 534 PART 4 Long-Term Financial Decisions FIGURE 12.5 (b) (a) Value V*
EBIT × (1 – T )
ka ks = cost of equity Annual Cost (%) Cost Functions
Capital costs and the optimal
capital structure ka = WACC
ki = cost of debt 0 Debt/Total Assets M = Optimal Capital Structure
Financial Leverage Cost Functions
Figure 12.5(a) plots three cost functions—the cost of debt, the cost of equity, and
the weighted average cost of capital (WACC)—as a function of financial leverage
measured by the debt ratio (debt to total assets). The cost of debt, ki , remains low
because of the tax shield, but it slowly increases as leverage increases, to compensate lenders for increasing risk. The cost of equity, ks , is above the cost of debt. It
increases as financial leverage increases, but it generally increases more rapidly
than the cost of debt. The cost of equity rises because the stockholders req...
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