Question

Firms try to define an optimal capital structure that minimizes their cost of capital. Explain how leverage (debt) plays a key role in determining the optimal mix.

Answer 1

Cost of Capital =Weight of Debt * Cost of Debt*(1-Tax Rate) + Weight if Equity* Cost of Equity + Weight of preferred stock* Cost of Preferred Stock
Optimal Capital structure is the proportion of debt , equity and preferred stock so as minimise capital structure without taking undue risks.

Leverage:
Leverage means use of debt in form of loan and bonds in funding a project or a company. This means increasing debt ratio or debt equity ratio.  This strategy is followed to increase Return on equity. Leverage is preferred because interest payments are tax deductible which decreases the cost of capital of a firm and increase the value of a firm. Leverage can be done by borrowing from banks or issuing debt for funding or to buyback shares.
Leverage helps in reducing cost of capital as interest payments are tax deductible.However increasing debt beyond certain level increases incremental cost of debt.Hence optimal leverage minimises cost of capital