Question

4. Cost of debt versus cost of equity. Because the cost of debt is lower than the cost of equity, firms must increase their use of debt as much as possible to increase the firm’s value. What is your answer to this argument?

Answer 1

A firm's value is inversely related to its weighted average cost of capital.

As any asset, a firm's value is the PV of its expected cash flows discounted at the WACC. That being so, the value of a firm would be maximum when the cost of capital is at its minimum. Hence, the objective of a firm of maximizing its value is achieved when the WACC is at its minimum.

The only way to lower WACC is to increase the proportion of that source of capital whcih has lower cost.

Hence, a firms value can be increased by increasing the proportion of debt [called financial leverage] in its capital structure.

But, that can be done only up to a certain proportion of debt in relation to total capital, which, is considered optimum.

Upto a certain level of debt considered normal for a business, both the equity holders and debt holders would be willing to supply funds at the lowest rate [which considers normal risk at normal level of debt]. Till that point is reached, the WACC will decrease as the debt % is increased from 0%. But, after that normal level of debt, the suppliers of capital [both equity and debt] would start feeling that the financial risk of the firm is increasing and would ask for higher returns. The cost of debt as well as equity would then go up at an inceasing rate. As a result the WACC which was decreasing would start to go up. That will mean that the firms value which, initially was increase with the proportion of debt, will start going down with the increase in the proportion of debt. Hence, a firm cannot add debt beyond the point after which WACC would increase.

The proportion of debt and equity at which the WACC will be the minimum giving the maximum firm value, is called the optimum structure. Thus, there is an optimum level of debt beyond which its proportion cannot be increased.