ASSIGNMENT

Describe the use of leverage on the optimal capital structure, focusing on the cost of capital, risk, cash flows, and return to the owners.

Debt is often viewed as bad and many believe that the goal of management should be to retire debt as quickly as possible. While this is true for many organizations, it is not true for all. There are two reasons why. The first is that it depends upon the type of organization and the second is based on risk level. For most not-for-profits, there is no tax advantage in paying interest while for-profits can reduce taxable income and therefore, taxes by claiming interest expense. Risk is not being able to service the debt (meet required payments); the more debt an organization has the more difficulty it may have in serving the debt. This is why small for-profits have a goal of not having debt.

Read Chapter 12 and take the practice quiz in MindTap.
Watch Chapter 11 video, Retained Earnings in MindTap.
Watch Chapter 12 video, Capital Structure, Business Risk and Financial Risk, and Signaling Theory in MindTap.
For-profit organizations that have debt financing need less equity financing. This raises the return on each dollar of equity the owners have provided.
Write a 2-3 page paper describing the optimal capital structure.
Ensure the following points are addressed.
The meaning of optimal capital structure
How leverage is used in the optimal capital structure
The effect of using leverage on the cost of capital
The sources of risk from using leverage.
The effects of using leverage on cash flows
The disadvantages of leverage to the owners.
The advantages of leverage to the owners.