Debt/Assets After-Tax Cost of Debt Cost of Equity
0% 4% 8%
10 4 8
20 4 8
30 5 8
40 6 10
50 8 12
60 10 14
70 12 16
0. Find the optimal capital structure (that is, optimal combination of debt and equity financing).
1. Why does the cost of capital initially decline as the firm substitutes debt for equity financing?
2. Why will the coat of funds eventually rise as the firm becomes more financially leveraged?
3. Why is debt financing more common than financing with preferred stock?
4. If interest were not a tax-deductible expense, what effect would that have on the firm's cost of capital? Why?
This question was asked on Apr 25, 2010 and answered on Apr 26, 2010.
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