Unformatted text preview: which the weighted average cost of capital, ka, is minimized. In Figure 12.5(a), CHAPTER 12 Leverage and Capital Structure 535 point M represents the minimum weighted average cost of capital—the point of
optimal financial leverage and hence of optimal capital structure for the firm. Figure 12.5(b) plots the value of the firm that results from substitution of ka in Figure 12.5(a) for various levels of financial leverage into the zero-growth valuation
model in Equation 12.11. As shown in Figure 12.5(b), at the optimal capital
structure, point M, the value of the firm is maximized at V*.
Generally, the lower the firm’s weighted average cost of capital, the greater
the difference between the return on a project and the WACC, and therefore the
greater the owners’ return. Simply stated, minimizing the weighted average cost
of capital allows management to undertake a larger number of profitable projects, thereby further increasing the value of the firm.
As a practical matter, there is no way to calculate the optimal capital structure implied by Figure 12.5. Because it is impossible either to know or to remain
at the precise optimal capital structure, fir...
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