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Capital Structure and Tax Shields"
Discussion Topic 2:
Please put the following paragraph in your own words.
The purpose of optimizing capital structure is to select that proportion of various forms of debts and equities that maximizes the firm’s value while minimizing the average cost of capital.
The Net Income to an optimal capital structure states that the total value of the firm changes with a change in the financial leverage. The NI approach holds true under certain assumptions. The NI approach assumes that the cost of debt is lower than the cost of equity. Therefore, an increase in the proportion of debt in the capital structure would result in a decrease in the firm’s average cost of capital. A lower cost of capital would result in an increase in the value of the firm.
The NI approach can be used to determine a firm’s optimum capital structure where the value of the firm is highest and the cost of the capital is lowest.
The Modigliani and Miller theorem is perhaps the most widely accepted capital structure theory. The first proposition, also referred to as the debt irrelevance theorem, states that the value of a firm is unaffected by its capital structure. The second proposition states that the required rate of return on equity increases as the firm’s debt equity ratio increases. This exactly offsets the less expensive funds represented by debt.
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