The cost of debt ki remains low because of the tax

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Unformatted text preview: remains low because of the tax shield, but it slowly increases as leverage increases, to compensate lenders for increasing risk. The cost of equity, ks, is above the cost of debt. It 442 PART 4 Long-Term Financial Decisions FIGURE 11.3 (b) (a) Value V* EBIT × (1 – T ) V= ka ks = cost of equity Annual Cost (%) Cost Functions and Value Capital costs and the optimal capital structure ka = WACC ki = cost of debt 0 Debt/Total Assets M = Optimal Capital Structure Financial Leverage increases as financial leverage increases, but it generally increases more rapidly than the cost of debt. The cost of equity rises because the stockholders require 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...
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