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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 )
ka ks = cost of equity Annual Cost (%) Cost Functions
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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- Spring '14