The major benefit of debt financing is the tax shield

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Unformatted text preview: of debt financing is the tax shield. The costs of debt financing include the probability of bankruptcy, caused by business and financial risk; agency costs imposed by lenders; and asymmetric information, which typically causes firms to raise funds in a pecking order of retained earnings, then debt, and finally external equity financing, in order to send positive signals to the market and thereby enhance the wealth of shareholders. Explain the optimal capital structure using a graphical view of the firm’s cost-of-capital functions and a zero-growth valuation model. The zero-growth valuation model can be used to define the firm’s value as its after-tax EBIT divided by its weighted average cost of capital. Assuming that EBIT is constant, the value of the firm is maximized by minimizing its weighted average cost of LG4 SELF-TEST PROBLEMS LG1 LG2 ST 11–1 Leverage and Capital Structure 453 capital (WACC). The optimal capital structure is the one that minimizes the WACC. Graphically, a...
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