Question

Discuss how the optimal capital structure is determined (i.e., what variable(s) suggest that a level of debt is optimal). Discuss the pros and cons of adding debt to a zero or low debt firm.

Answer 1

The optimal capital structure is one with optimal D/E ratio. This can be determined by following ways:
1. Choosing a debt equity ratio which optimizes total cost of capital employed without increasing the risk to the firm by taking excess debt. An optimal Cost of capital will bring maximum value to firm.
2. Optimal capital structure can be obtained by benchmarking debt equity ratio with similar industries with similar risk profile and projects.
3. Determining debt level at such a ratio that it has good rating from the rating agency. Higher debt level increases the cost of debt as a poor rating increase the interest rate on debt.

Pros of adding debt
1. Debt reduces the cost of capital as interest payments are tax deductible. Hence it increase the value of firm.
2. It the Return on capital employed and growth of firm is very high then debt can increase the value of firm.

Cons of adding debt.
1.It increases the risk of firm and the cost of new debt might be higher than old debt.
2. During downturn the interest paying capacity of firm will be hit which will reduce the rating of the film making debt very costly.
3. Debt payments are to be made regularly unlike dividend which are at the discretion of the management.

Best of luck. God Bless