5. Capital structure decisions and firm value Aa Aa E 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, the firm should try to set a capital structure that maximizes the stock price, or shareholder value. This is called the optimal capital structure. Which of the following statements regarding a firm’s optimal capital structure is true? O The optimal capital structure maximizes the firm’s cost of equity. The optimal capital structure maximizes the firm’s earnings per share (EPS). The optimal capital structure maximizes the firm’s stock price. The optimal capital structure maximizes the firm’s cost of debt.
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. M M M M M M M M M M M M M M கககககககக Workshop Talking Points Interest paid on debt is deducted from a 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. 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. A decrease in debt financing increases the risk of bankruptcy, and managers are encouraged to invest in high-risk projects.
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