and is a function ofthe firm’s cash flowsand its cost of
capital. If we assume that the cash flows to the firm are
unaffectedby thechoice offinancing mix andthe cost of
capitalisreducedasaconsequenceofchangingthefinancing
mix,thevalueofthefirmwillincrease. Iftheobjectivein
choosingthefinancingmixforthefirmisthemaximization
of firm value, we can accomplish it, in this case, by
minimizingthecostofcapital.Inthemoregeneralcasewhere
thecash flowstothefirmareafunctionofthedebt-equity
mix,theoptimalfinancingmixisthemixthatmaximizesfirm
value.
14
We need three basic inputs to compute the cost of
capital—thecostofequity,theafter-taxcostofdebt,andthe
weights on debt and equity. Thecosts of equity and debt
changeasthedebtratiochanges,andtheprimarychallengeof
this approach is in estimating each of these inputs.
Letusbeginwiththecostofequity.Wearguedthatthebeta
ofequitywillchangeasthedebtratiochanges.Infact,we
estimated the levered beta as a function of the market
debt-to-equity ratio of a firm, the unlevered beta and the
firm’s marginal tax rate:
Thus,ifwecanestimatetheunleveredbetaforafirm,wecan
useittoestimatetheleveredbetaofthefirmateverydebt
ratio.Thisleveredbetacanthenbeusedtocomputethecost
of equity at each debt ratio.