Question

Capital Structure and Firm Value a. Show graphically (in Debt-Value space) how firm value is affected by debt when i) there are no corporate taxes, corporate debt is riskless and there are no bankruptcy costs, ii) there are corporate taxes, but corporate debt is riskless and there are no bankruptcy costs, and iii) there are corporate taxes, but corporate debt is risky and there are bankruptcy costs. b. What do each of the scenarios above imply about an optimal capital structure? c. Which scenario is more realistic? Why? d. Under the scenario in iii, show graphically what happens to a) the cost of debt, b) the cost of equity, and c) weighted average cost of capital (WACC) as the firm adds more debt. e. What is the relationship between WACC and firm value and what does this imply about the optimal capital structure?

Answer 1

Aus A Value no debt Debt Aus D Cest of Capital Cist of leauty W.Ale list of Debt oplind Debt

pls find above graphs for A i , ii & iii as well as the answer to D ( both in one image)

Ans B - From the above we can conclude , if there is no tax then accumulating debt decreases value of firm. However if there is tax then up to a certain level of debt corporates can take benefit of interest costs and improve their value . But after a certain level the cost of debt servicing brings down the value of the firm. If the debts are risky implying higher interest costs initial tax benefits are higher but after the optimal level the costs increase faster thus depleting value. Similarly financial distress and bankruptcy costs deplete the value even faster

C) in my opinion Scenario 3 is most realistic as corporate debts carry a certain amount of risk and excess debt can lead to financial distress

D) answer is included in the image above

E) WACC is actually the lowest when there is an optimal mix of debt and equity , A certain amount of debt helps in tax benefits due to interest cost deduction and thus could be added to the capital structure. But beyond the optimal point its too costly to service the debt so costs outweigh the tax benefits.