Question

Define optimal capital structure and its link with the cost of capital

Answer 1

Optimal capital structure is a financial measurement that firms use to determine the best mix of debt and equity financing to use for operations and expansions. This structure seeks to lower the cost of capital so that a firm is less dependent on creditors and more able to finance its core operations through equity.

 In general, the optimal capital structure is a mix of debt and equity that seeks to lower the cost of capital and maximize the value of the firm. To calculate the optimal capital structure of a firm, analysts calculate the weighted average cost of capital (WACC) to determine the level of risk that makes the expected return on capital greater than the cost of capital.

By calculating the cost of debt and the cost of equity, analysts multiply the cost of debt by the weighted average cost of debt and the cost of equity by the weighted average cost of equity and add up the results from each security involved in the total capital of the company.

Answer 2

Answer:

Debt is less risky than equity, the cost of debt is lower.

Explanation:

Debt is less risky than equity, the cost of debt is lower.

Interest payments take precedence over dividends, and debt holders take precedence in the case of a liquidation, the required return for debt investors is lower than the required return for stock investors. Debt is also less expensive than equity since interest payments are tax deductible, but dividend payments are made after taxes.