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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
ka earnings before interest and taxes
the after-tax operating earnings available to the debt and
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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- Spring '14