Choosing a capital structure that maximizes equity value is the same as choosing one that maximizes firm value.

Question

BlackTom AI · Accepted Answer

In corporate finance, the statement claims that choosing a capital structure that maximizes equity value is the same as choosing one that maximizes firm value.

First, consider what each objective represents: firm value is the total value of the company to all stakeholders, typically the value of its operations plus any tax benefits from debt and minus bankruptcy and agency costs. Equity value is the residual claim on the firm’s value after debt holders are paid, i.e., firm value minus debt.

Next, analyze the relationship between these two objectives. A capital structure that increases leverage (debt) can raise equity value through tax shields and higher return on equity, but it also raises the risk of financial distress and potential agency costs. While debt can boost equity value up to a point, excessive debt can reduce firm value through increased bankruptcy risk and higher expected costs of financial distress.

Therefore, the leverage that maximizes equity value is not guaranteed to maximize the overall firm value. The optimal capital structure is usually the balance that maximizes firm value by weighing the tax benefits of debt against the costs of financial distress and agency costs; this does not automatically coincide with maximizing equity value alone.

Option analysis:
- If the statement were that these two goals are the same, that would imply a single optimal structure for both metrics. In reality, the debt level that maximizes firm value may differ from the debt level that maximizes equity value, due to the subtraction of debt from firm value to obtain equity value and the associated risk and cost implications.

Since only one option is presented and it states 'True,' this option is not generally correct given standard capital-structure theory. The more accurate stance is that maximizing equity value and maximizing firm value are related but not identical objectives, and they can lead to different optimal capital structures.

SP25-BL-BUS-F402-4299 Capital Structure I

Choosing a capital structure that maximizes equity value is the same as choosing one that maximizes firm value.

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