Which one of these relationships will exist if a firm is operating under its optimal capital structure?
A)The net present value of the firm will equal zero.
B)The firm's cost of capital will equal the risk-free rate.
C)The present value of the financial distress costs will equal the present value of the tax shield on debt.
D)The value of the firm will equal the maximum value obtainable according to the MM theories.
E)The firm will be financed with equal amounts of long-term debt and equity.

Question

Quizplus · Accepted Answer

When a firm is operating under its optimal capital structure, the present value of the financial distress costs (the costs associated with financial distress due to excessive debt) will be equal to the present value of the tax shield on debt (the tax benefits associated with debt financing). This balance indicates that the firm is utilizing the right amount of debt and equity to maximize the value of the firm. None of the other options necessarily show that a firm is operating under its optimal capital structure.

Which One of These Relationships Will Exist If a Firm