actions that increase financial leverage (such as stock
buybacks funded with debt) increase firm value, which
suggests that value is affected by financial leverage.
Techniques for Evaluating Capital Structure
There are twobasic techniques for evaluating the optimal
capitalstructureforafirm.Thefirst iscenteredaroundthe
costofcapitalapproach,withtheobjectivebeingfindingthe
debt ratio that minimizes thecost of capital, whereas the
secondusestheAPVapproachtofindthelevelofdebtthat
maximizes firm value.
Cost of Capital and Financial Leverage
Inordertounderstandthelinkbetweenthecostofcapitaland
optimalcapitalstructure,wedrawontherelationshipbetween
firmvalueandthecostofcapital.Intheearliersection,we
notedthatthevalue oftheentire firmcanbeestimated by
discountingtheexpectedcashflowstothefirmatthefirm’s
costofcapital.Thecashflowstothefirmcanbeestimatedas
cash flowsafteroperating expenses, taxes,and any capital
investments needed to create future growth in both fixed
assets and working capital, but before financing expenses.
The value of the firm can then be written as: