11 where ebit ebit t 1 t ka earnings before interest

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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 ) V= ka ks = cost of equity Annual Cost (%) Cost Functions and Value 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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