Why focus on the optimal capital structure? Capital structure decisions involve

Question

Why focus on the optimal capital structure? 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, a firm should try to set 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: Maximizes the net income Maximizes the dividends Maximizes the weighted average cost of capital (WACC) Minimizes the weighted average cost of capital (WACC) 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 A decrease in debt financing increases the risk of bankruptcy, and managers are encouraged to invest in high-risk projects. An increase in debt financing beyond a certain point increases the risk of bankruptcy and financial distress. Interest paid on debt is deducted from the firm's pretax income, thus reducing the amount of taxes that it owes. An increase in debt financing increases the taxes that a company owes. In an event of liquidation, creditors will get their claims over the firm's assets before common shareholders.

Explanation / Answer

1. D - Minimizes the WACC

2. B, C and E are TRUE

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