Financing Decisions and The Cost of Capital. The Capital Structure Question:. How should a firm structure the right-hand side of its balance sheet? Debt vs. Equity – the choice for our purposes. We have seen how to do capital budgeting when the firm has debt in its capital structure.
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VU = VL - MM Proposition I.
Cost of capital: r (%)
Cost of capital: r(%)
Value of firm underMM with corporatetaxes and debt
Value of firm (V)
Present value of taxshield on debt
VL = VU + TCB
Present value offinancial distress costs
V = Actual value of firm
VU = Value of firm with no debt
Optimal amount of debt
Source: Ibbotson Associates 2003