Capital structure decisions involve the ways a firm?s assets are financed and ar
ID: 2653642 • Letter: C
Question
Capital structure decisions involve the ways a firm?s assets are financed and are often presented as a percentage of the type of financing used, such as debt, preferred stock, and common equity. As with all financial decisions, the firm should try to set a capital structure that maximizes the stock price, or shareholder value. This s called the optimal capital structure, Which of the following statements regarding a firm?s optimal capital structure s true The optimal capital structure maximizes the firm?s cost of debt. The optimal capital structure minimizes the firm?s weighted average cost of capital (WACC). The optimal capital structure maximizes the firm?s cost of equity. The optimal capital structure maximizes the firm?s earnings per share (EPS). Understanding the impact of debt in the capital structure Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key Issues related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have made some mistakes. Review the list and identify which items are correct. Check all that apply. Workshop Talking Points An Increase in debt financing decreases the risk of bankruptcy. An increase in the risk of bankruptcy is likely to reduce the firm?s free cash flows in the future. The pretax cost of debt increases as the firm?s risk of bankruptcy increases. An increase in debt financing beyond a certain point is likely to increase the cost of equity. Risks of bankruptcy increase management spending on perquisites and increase agency costs.Explanation / Answer
1.c the optimal capital structure minimizes the firm's WACC.
the optimal capital structure maximizes Firm''s EPS.
The optimal capital structure is mix of debt, equity and preferred that will maximize company's EPS and minimizes WACC.
2.
b. An increase in the risk of bankruptcy is likely to reduce the firm's free cash flows in the future.
c.The pretax of cost of debt increases as the firm's risk of bankruptcy increases.
d. An increase debt financing beyond the increases the cost of equity.
The risk of bankruptcy increases with increased debt load. The company increased the debt financing beyond the optimum capital structure cost of debt increases it would impact the WACC, to certain level WACC would be minimize but increased in debt after certain level would increase WACC to higher level.