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, 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 firms optimal capital structure is true?

The optimal capital structure minimizes the firms weighted average cost of capital.

The optimal capital structure maximizes the firms cost of equity.

The optimal capital structure maximizes the firms cost of debt.

The optimal capital structure maximizes the firms earnings per share (EPS).

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.

An increase in debt financing beyond a certain point increases the risk of bankruptcy and financial distress.

Interest paid on debt is deducted from a firms pre-tax income, thus reducing the amount of taxes that it owes.

A decrease in debt financing increases the risk of bankruptcy, and managers are encouraged to invest in high-risk projects.

An increase in debt financing increases the taxes that a company owes.

In an event of liquidation, creditors will get their claims over a firms assets before common shareholders