A company\'s capital structure decisions address the ways a firm\'s assets are f

Question

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

Explanation / Answer

a.

Optimal capital structure means a combination of debt and equity in capital structure which gives lowest weighted average cost of capital. The goal of management of company is to minimize the WACC of the company. if WACC of company is low then value of rim would be high.

So option (B) is correct asnwer.

b.

The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. When debt increase beyon optimal level then risk of bankruptcy increase. During liquidation creditors get payment first from proceeds from sale of assets than firm equity.

The theory recognizes the tax benefit from interest payments. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.

So, Option (A), option (B) and option (E) is correct answer.

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