If a firm's optimal capital structure is relatively flat,

Question

Quizplus · Accepted Answer

If a firm's optimal capital structure is relatively flat, it means the firm's cost of capital does not vary significantly with changes in the debt-to-equity ratio. Thus, the firm's management should not be overly concerned about small deviations from its optimal debt ratio. Using 50% debt and 50% equity financing (option B) may not be appropriate as it assumes that the firm's optimal capital structure is at the 50% debt level. Option A is incorrect because even with a flat optimal capital structure, the cost of short-term financing and long-term financing may not be equal. Option D is also incorrect because increasing equity financing will likely increase the firm's cost of capital. If a firm's optimal capital structure is relatively flat, it means that the cost of capital does not change significantly with changes in the debt to equity ratio. Therefore, small deviations from the optimal level of debt should not have a significant impact on the firm's cost of capital. However, this does not mean that the firm should not be concerned about its debt ratio, as excessive debt can still lead to bankruptcy or financial distress.

If a Firm's Optimal Capital Structure Is Relatively Flat