1. Capital structure decisions and firm value Aa Aa Why focus on the optimal cap
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1. Capital structure decisions and firm value Aa Aa Why focus on the optimal capital structure? A company's capital structure decisions address the ways a firm's assets are financed (using debt, preferred stock, and common equity capital) and is often presented as a percentage of the type of financing used. As with all financial decisions, a firm should try to establish a capital structure that maximizes the stock price, or shareholder value. This is called the optimal capital structure; it is also the debt-equity mix that: O Maximizes the firm's weighted average cost of capital Maximizes the firm's dividends Minimizes the firm's weighted average cost of capital o Maximizes the company's net income 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.Explanation / Answer
Optimal capital structure is the debt-equity mix that maximizes the firm value by minimizing weighted average cost of capital.
- Cost of debt increases with risk of bankruptcy increases. Hence, the first statement is correct.
- The second statement is incorrect because there isn't any relationship between risk of bankruptcy and management spending.
- Third statement is incorrect as well. Increase in bankruptcy leads to increase in cost of capital and do not impact free cash flows.
- Fourth is correct. Increase in leverage beyond a certain point make the equity risky, which increases the cost of equity.
- Fifth statement is correct as well. Increase in leverage increases the risk of bankruptcy.
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