Question

Moon Corp. has a required return on debt of 10 percent, a required return on equity of 18

percent, and a 34 percent tax rate. Moon's management has concluded that a financing mix

of 50 percent debt, 50 percent equity is desirable. Given this information, should Moon

accept this investment?

Answer 1

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost.

Explanation: