Explain the optimal capital structure using a lg4

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Unformatted text preview: an be used to define the firm’s value as its after-tax EBIT divided by its weighted average cost of capital. Assuming that EBIT is constant, the value of the firm is maximized by minimizing its weighted average cost of capital (WACC). The optimal capital structure is the one that minimizes the WACC. Graphically, although both debt and equity costs rise with increasing financial leverage, the lower cost of debt causes the WACC to decline and then rise with increasing financial leverage. As a result, the firm’s WACC exhibits a U-shape, whose minimum value defines the optimal capital structure that maximizes owner wealth. SELF-TEST PROBLEMS LG1 LG2 ST 12–1 Discuss the EBIT–EPS approach to capital structure. The EBIT–EPS approach evaluates capital structures in light of the returns they provide the firm’s owners and their degree of financial risk. Under the EBIT–EPS approach, the preferred capital structure is the one that is expected to provide maximum EPS over the firm’s expected range of EBIT. Gr...
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