The optimal capital structure has been achieved when the:
A) debt-equity ratio is equal to 1.
B) weight of equity is equal to the weight of debt.
C) cost of equity is maximized given a pretax cost of debt.
D) debt-equity ratio is such that the cost of debt exceeds the cost of equity.
E) debt-equity ratio results in the lowest possible weighted average cost of capital.

Question

Quizplus · Accepted Answer

The optimal capital structure is the one that results in the lowest possible weighted average cost of capital. This means that the debt-equity ratio should be such that the total cost of capital is minimized. If the company has too much debt, the cost of debt will increase due to higher interest payments and this will increase the weighted average cost of capital. On the other hand, if the company has too much equity, the cost of equity will increase due to higher expectations of returns from shareholders and this will also increase the weighted average cost of capital. Therefore, the ideal capital structure is the one that balances the costs of debt and equity to minimize the weighted average cost of capital.

The Optimal Capital Structure Has Been Achieved When The