The optimal capital structure what then is an optimal

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Unformatted text preview: l Structure What, then, is an optimal capital structure, even if it exists (so far) only in theory? To provide some insight into an answer, we will examine some basic financial relationships. It is generally believed that the value of the firm is maximized when the cost of capital is minimized. By using a modification of the simple zerogrowth valuation model (see Equation 7.2 in Chapter 7), we can define the value of the firm, V, by Equation 11.11. V EBIT (1 ka T) (11.11) where EBIT EBIT T (1 T) ka earnings before interest and taxes tax rate the after-tax operating earnings available to the debt and equity holders weighted average cost of capital Clearly, if we assume that EBIT is constant, the value of the firm, V, is maximized by minimizing the weighted average cost of capital, ka. Cost Functions Figure 11.3(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 ,...
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