Question

Explain why maximizing expected cash flows is the best financing choice.

Answer 1

The cost of debt is less expensive than equity, because it is less risky. The required return needed to compensate debt investors is less than the required return needed to compensate equity investors, because interest payments have priority over dividends and debt holders receive priority in the event of liquidation. Debt is also cheaper than equity, because companies get tax relief on interest, while dividend payments are paid out of after-tax income.

However, there is a limit to the amount of debt a company should have, because an excessive amount of debt increases interest payments, and the volatility of earnings and the risk of bankruptcy. This increase in the financial risk to shareholders means that they will require a greater return to compensate them, which increases the WACC — and lowers the market value of a business. So, the optimal structure involves using enough equity to mitigate the risk of being unable to pay back the debt taking into account the variability of the business cash flow.

Thus, maximizing expected cash flows is the best financing choice as the company with volatile cash flow, will have little debt and a large amount of equity.