Question

Define the capital structure (leverage) of a firm. What do you consider to be the optimal capital structure for a firm?

c. What was EBIT?

Answer 1

Capital structure is level of debt and equity used by firm to finance it's total assets. Debt includes bonds and loans, equity comprises of common stock and preferred stocks.

Optimal capital structure is the best level of debt and equity which maximizes the firm value. As interest expenses are tax deductible the debt financing is cheaper compared to equity financing but as debt level increases the riskiness of firm also increases hence the level at which weighted average cost of capital is minimum that is called the optimal capital structure. WACC is used as discounting factor so lesser the WACC higher would be the present value of a firm.

EBIT is abbreviation for earnings before interest and taxes its also known as operating profit. EBIT is calculated by subtracting all the operating expenses from sales. Interest expenses are not operating expense for non banking firms. Different firm may have different level of debt so interest expense would vary so to compare them operating profit is considered as better measure. It represents the operating efficiency of a firm.