Elements of Numerical Mathematical Economics with Excel

9.10. Optimal capital structure and the firm cost of capital

In this example, we will look at a typical issue of Corporate Finance, which is the one of finding the optimal firm capital structure, maximizing the firm value and, at the same time, minimizing the cost of capital (e.g., the Weighted Average Cost of Capital: WACC).

Let us assume we have an underlevered publicly traded firm with a capital structure not considered optimal by its Chief Financial Officer (CFO), according to the Modigliani–Miller theory ⁴ and other Capital Structure theories. This is because the firm does not carry any debt and the current Debt-to-Equity (D/E) ratio is zero. The CFO knows that all the other competitors use at least either some bank debt or corporate ...