Although tax laws can change, and firm’s can change their operations and/or modes of financing, the...

Although tax laws can change, and firm’s can change their operations and/or modes of financing, the determination of the firm’s optimal capital structure is a relatively simple process. True or False?

Expert Solution

False. Optimal capital structure has lowest weighted average cost of capital for the company. The typical capital structure of a firm consists of debt and equity and debt carries tax shield with it which increases the value of the firm. But the trade-off occurs as higher debt also increases the distress costs which causes cost of equity to rise.

Wacc = %debt * ( cost of debt) * (1-tax) + % equity * ( cost of equity)

It is very difficult to understand the effect of increasing debt. Debt being a cheaper aource of finance, one would think increasing debt can lower WACC. But due to increased risk for equity investors, cost of equity rises. Also any additional debt can come at increased costs too. It is difficult to know whether the decrease in wacc from issuance of debt was more than increase in wacc due to cost of equity increase. There is no analytical method to find the best debt to equity ratio. It depends on a lot of factors both inside the company and outside. Management oftern tries to keep the capital structure within a range. Thus, it is a complex process of determining optimal capital structure.

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