The firmvalue is optimized at about 40% debt,which is
consistent with theresults of thecost of capital approach.
Theseresultsare,however,verysensitivetoboththeestimate
of bankruptcy cost as a percent of firm value and the
probabilities of default.
Comparing the Cost of Capital and APV Approaches
TheadvantageoftheAPVapproachisthatitseparatesthe
effects of debt into different components and allows the
analystto use differentdiscountratesfor eachcomponent.
Wealsodonotassumethatthedebtratiostaysunchanged
forever,whichisanimplicitassumptioninthecostofcapital
approach.Instead,wehavetheflexibilitytokeepthedollar
valueofdebtfixedandtocalculatethebenefitsandcostsof
the fixed dollar debt.
Theseadvantageshavetobeweighedagainstthedifficultyof
estimatingprobabilitiesofdefaultandthecostofbankruptcy.
In fact,many analystswhouse the adjustedpresent value
approachignoretheexpectedbankruptcycosts,leadingthem
totheconclusionthatfirmvalueincreasesasfirmsborrow
money.Notsurprisingly,theyconcludethattheoptimaldebt
ratioforafirmis 100 percentdebt.Ingeneral,withthesame