The financial manager of a firm determines the following schedules of cost of debt and cost of equity for various combinations of debt financing:

a. Find the optimal capital structure (that is, optimal combination of debt and equity financing).
b. Why does the cost of capital initially decline as the firm substitutes debt for equity financing?
c. Why will the cost of funds eventually rise as the firm becomes more financially leveraged?
d. Why is debt financing more common than financing with preferred stock?
e. If interest were not a tax-deductible expense, what effect would that have on the firm’s cost of capital? Why?

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Debt/Assets After-Tax Cost of Debt Cost of Equity 8% 096 10 20 30 40 50 60 70 4% 10 12 14 16 10 12