The financial manager of a firm determines the following schedules of cost of debt and cost of equity for various combinations of debt financing:

Debt/Assets		After-Tax Cost of Debt		Cost of Equity
0	%	4	%	9	%
10		4		9
20		4		9
30		6		10
40		6		10
50		7		12
60		9		14
70		11		15

Find the optimal capital structure (that is, optimal combination of debt and equity financing). Round your answers for the capital structure to the nearest whole number and for the cost of capital to one decimal place.

The optimal capital structure: % debt and % equity with a cost of capital of %

Why does the cost of capital initially decline as the firm substitutes debt for equity financing?

The cost of capital initially declines because the firm cost of debt is -Select-higherlowerItem 4 than the cost of equity.

Why will the cost of funds eventually rise as the firm becomes more financially leveraged?

As the firm becomes more financially leveraged and riskier, the cost of debt and equity will -Select-risefallItem 5 and cause the cost of capital to increase.

Why is debt financing more common than financing with preferred stock?

Debt financing is more common than financing with preferred stock because of -Select-the tax advantagethe risk advantagethe lower dividend payout ratioItem 6 which makes the cost of the debt financing -Select-higher thanlower thanequal toItem 7 the cost of the preferred stock.

If interest were not a tax-deductible expense, what effect would that have on the firms cost of capital?

If interest were not a tax deductible, the cost of debt would be -Select-higherlowerItem 8 , -Select-decreasingincreasingItem 9 the cost of capital.