The absence of debt means the absence of financial leverage. Equity in a firm with no debt is therefore called unlevered equity. Because the present value of the equity cash flows is $$30,000,$ you can raise $$30,000$ by selling all the unlevered equity in your firm. Doing so allows you to keep the NPV of $$6000$ as profit after paying the investment cost of $$24,000.$ In other words, the project$$s NPV represents the value to the initial owner of the firm $($in this case, the entrepreneur$)$ created by the project. As an alternative, you also consider borrowing some of the money you will need to invest. Suppose the business$$s cash flow is certain to be at least $$16,000.$ Then you can borrow $$15,000$ at the current risk$-$free interest rate of $5\%.$ You will be able to pay the debt of $$15,000$ X $1\mathrm{.}05=$ $$15,750$ at the end of the year without any risk of defaulting. How much can you raise selling equity in your business right now? Equity in a firm that also has outstanding debt is called levered equity. After the debt is repaid, equity holders can expect to receive $$34,50015,750=18,750.$ What discount rate should we use to value levered equity? What expected return will investors demand? It$$s tempting to use the same $15\%$ equity cost of capital as before. In that case, by selling levered equity, you could raise $$18,750/1\mathrm{.}5=16,304.$ If this result were correct, then using leverage would allow you to raise a total amount, including the debt, of $15,000+16,304=31,304$ or $1304$ more than in the case without leverage. Thus, it would seem that simply financing a project with leverage can make it more valuable. But if this sounds too good to be true, it is$.$ Our analysis assumed that your firm$$s equity cost of capital remained unchanged at $15\%$ after adding leverage. The optimal capital structure depends on market imperfections such as taxes, financial distress costs, agency costs, and asymmetric information as follows: $1.$ Make sure of the interest tax shield if your firm has consistent taxable income. $2.$ Balance the tax benefits of debt against the costs of financial distress when determining how much of the firm$$s income to shield taxes with leverage. $3.$ Consider short$-$term debt for external financing when agency costs are significant. $4.$ Increase leverage to signal managers$$ confidence in the firm$$s ability to meet its debt obligations. Investors understand that bankruptcy is costly for managers. $5.$ Be mindful that investors are aware that you have an incentive to issue securities that you know are overpriced. $6.$ Rely first on retained earnings, then debt, and finally equity. This pecking order of financing alternatives will be most important when managers are likely to have a great deal of private information regarding the value of the firm. $7.$ Do not change the firm$$s capital structure unless it departs significantly from the optimal level.