Question

What is a firm’s optimal capital structure based on the financial relationships between the after-tax cost of debt, the cost of equity, and the weighted average cost of capital?

Explain how it differs from the optimal capital structure proposed by the Modigliani and Miller (MM) model with corporate taxes.

Answer 1

Firm optimal capital structure is a balanced mix of equity capital as well as debt capital in order to help the business to achieve the maximization of the value through gaining in proper allocation of its capital.

Relationship between after tax cost of debt and cost of equity is that when after tax cost of debt is lower, it will be impacted into lower overall cost of capital and it will also be resulting into lower cost of equity so, the overall weighted average cost of capital will also be lower.

It is mostly related to value of benefits which are yielding to debt capital due to tax deduction of interest expenses and there must be a balance between benefits due to tax expenses and cost of financial distress.

It is different from ModiGliani and Miller approach because this optimal capital structure is focused at a trade-off between finding an optimum mix of both capital whereas modigliani and Miller approach is always focused at maintaining a high level of debt capital into the overall capital structure in order to gain from tax deduction.