Why focus on the optimal capital structure? A companys capital structure decisions address the ways a firms 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, a firm should try to establish a capital structure that maximizes the stock price, or shareholder value. This is called the optimal capital structure; it is also the debt-equity mix that:

a. maximizes the firms dividends.

b. minimizes the firms weighted average cost of capital.

c. maximizes the companys net income.

d. maximizes the firms weighted average cost of capital.

Understanding the impact of debt in the capital structure. 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.

Workshop Talking Points Check all that apply.

a. An increase in debt financing decreases the risk of bankruptcy.

b. The pre-tax cost of debt increases as a firms risk of bankruptcy increases.

c. An increase in the risk of bankruptcy is likely to reduce a firms free cash flows in the future.

d. An increase in debt financing beyond a certain point is likely to increase the firms cost of equity.

e. Risks of bankruptcy increase management spending on perquisites and increase agency costs.