Slide MGT411 Slide13

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Chapter 16

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-2

Optimal Financial Structure

• The domestic theory of optimal financial structure must be modified considerably to encompass the multinational firm.

• Most finance theorists are now in agreement about whether an

optimal financial structure exists for a firm, and if so, how it can be determined.

• When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of

debt and equity that minimizes the firm’s cost of capital for a given level of business risk.

• As the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-3

Optimal Financial Structure

•

_{The following exhibit illustrates how the}

cost of capital varies with the amount of

debt employed.

•

_{As the debt ratio increases, the overall}

cost of capital (k

WACC

) decreases because

of the heavier weight of low-cost (due to

tax-deductibility) debt ([k

_d

(1-t)]