Question

1. Optimal Capital Structure: Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?  

2. Financial Leverage: Why is the use of debt financing referred to as a financial "leverage"  

3. Capital Structure Goal: What is the basic goal of financial management with regard to capital structure?

Answer 1

1. There is no identifiable debt-equity ratio that can maximize the value of the firm. Factors such as bankruptcy costs, agency costs and asymmetric information cannot be easily identified ,so there is no debt-equity ratio that can maximize the value of the firm. A firm should raise debt, only if it can afford the costs attached to it, if by any chance, the debt becomes too expensive the firm can become highly leveraged.

2. Financial leverage is the use of borrowed money to buy assets. A firm borrows money because debt is cheaper and it helps avoids all equity within the firm. Leverage helps maximize the gains and losses. Using cheaper debt as a source of finance helps to magnify gains at the same time if, firm is unable to pay off debt it lead to bankruptcy costs and losses.

3.The basic goal of a financial management is to use a appropriate mix of debt and equity to finance the operations of the firm and to purchase assets of the firm.