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Determinants and benefits of Optimal Capital Structure

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What external factors affect the optimal capital structure?
What is the benefit of being at the optimal capital structure?

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Solution Summary

The solution explains various factors affecting the choice for optimal capital stucture and how the optimal capital struture helps the organizations. The solution has approx 400 words and presents examples of various situations.

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External factors include macro-economic factors
In good economic times, firms will generate higher earnings and be able to service more debt. In recessions, earnings will decline and with it the capacity to service debt. In fact, both the level of risk-free rate and the magnitude of default spreads can affect optimal debt ratios.

(a) Level of Interest Rates
As interest rates decline, debt becomes cheaper and more attractive. While this may seem intuitive, the effect is muted by the fact that lower interest rates also reduce the cost of equity. In fact, changing the risk-free rate has a ...

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