Thereasonforminimizingthecostofcapitalisthatdoingso
maximizesthevalueofthefirm.Valuingtheexpectedcash
flows in Illustration 6.2 using the lower expected cost of
capital estimated using the optimal debt ratio would have
increasedfirmvaluebyabout5%(fromthecurrentmarket
value).
APV and Financial Leverage
Aswe notedearlierin thischapter, intheadjustedpresent
value(APV)approachwebeginwith thevalueofthefirm
withoutdebt.Asweadddebttothefirm,weconsiderthenet
effectonvaluebylookingatboththebenefitsandthecostsof
borrowing. The value of the levered firm can then be
estimatedatdifferentlevelsofthedebt,andthedebtlevelthat
maximizes firm value is the optimal debt ratio.
The unlevered firm value is not a function of expected
leverage and can be estimated as described in the earlier
section—bydiscountingthefreecashflowstothefirmatthe
unleveredcostofequity.Infact,ifwedonotwanttoestimate
thisvalueandtakethemarketvalueofthefirmascorrect,we
couldbackouttheunleveredfirmvaluebysubtractingthetax