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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
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