The cost of equity ks is above the cost of debt it

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Unformatted text preview: uire a higher return as leverage increases, to compensate for the higher degree of financial risk. The weighted average cost of capital (WACC) results from a weighted average of the firm’s debt and equity capital costs. At a debt ratio of zero, the firm is 100 percent equity-financed. As debt is substituted for equity and as the debt ratio increases, the WACC declines because the debt cost is less than the equity cost (ki ks). As the debt ratio continues to increase, the increased debt and equity costs eventually cause the WACC to rise (after point M in Figure 12.5(a)). This behavior results in a U-shaped, or saucer-shaped, weighted average cost-ofcapital function, ka. optimal capital structure The capital structure at which the weighted average cost of capital is minimized, thereby maximizing the firm’s value. A Graphical View of the Optimal Structure Because the maximization of value, V, is achieved when the overall cost of capital, ka, is at a minimum (see Equation 12.11), the optimal capital structure is that at...
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