# River Cruises' management now understands that the trade-off theory of optimal capital structure implies managers will increase

## Question:

Figure 16.7 The trade-off theory of capital structure. The curved blue line shows how the market value of the firm at first increases as the firm borrows but finally decreases as the costs of financial distress become more and more important. The optimal capital structure balances the costs of financial distress against the value of the interest tax shields generated by borrowing.

a. Start with a no-tax economy. Continue to assume that River Cruises' required return on assets is 12.5% and return on debt is 10%. In a spreadsheet, calculate requity, WACC, and rdebt for debt-equity ratios ranging from 0 to 2.5 in increments of .1. Does WACC vary with the D/E ratio? Compare your plot to Figure 16.3.

FIGURE 16.3 MM's proposition II with a fixed interest rate on debt. The expected return on River Cruises' equity rises in line with the debt-equity ratio. The weighted average of the expected returns on debt and equity is constant, equal to the expected return on assets.

b. Now assume the corporate tax rate is 35%. Repeat part (a). What happens to WACC as D/E increases?

c. What seems to be the optimal capital structure?

Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a...

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**Related Book For**

## Fundamentals of Corporate Finance

**ISBN:** 978-1259722615

9th edition

**Authors:** Richard Brealey, Stewart Myers, Alan Marcus