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Valuation: Measuring and Managing the Value of Companies, Fifth Edition
Chapter 23 Solutions
Capital Structure
1. Optimal capital structure is that which maximizes the value of the firm. According to a
widely used analysis, on a graph where the horizontal axis is leverage and the vertical
axis is the value of the firm, the value of the firm will rise as leverage increases from zero
to a particular value and then decline after that point. The point of maximum corporate
2. Having less debt allows more freedom and allows the firm to take on more risky projects.
Companies without debt that are well managed and in cutting-edge industries (e.g.,
3. The factors used in credit ratings fall into two general categories: coverage and size.
Coverage refers to the extent the firm has its interest costs and other fixed costs covered
4. Acceptable coverage ratios vary by industry. Telecom companies can have lower
5. There are three general stages in establishing an effective capital structure: (1) determine
the funding needed, (2) develop a target capital structure, and (3) develop tactical plans
6. Leverage should be lower for companies with lower returns, higher growth potential and
risk, and highly specific assets and capabilities. Most start-ups have these characteristics.
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7. The pecking order theory says that a firm will first use internal financing (retained
earnings), then debt financing, and then equity financing. One of the reasons for firms
8. For the firm and its current stakeholders, convertible debt makes more sense for a
company with lower growth opportunities like BMW rather than Tesla, because of the
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