What is the Optimal Capital Structure?
In a perfect world environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. This is known as the Independence hypothesis: firm value is independent of capital structure. Independence Hypothesis – If we have perfect capital markets, capital structure is irrelevant. – In other words, changes in capital structure do not affect firm value. Dependence Hypothesis – Increasing leverage does not increase the cost of equity. – Since debt is less expensive than equity, more debt financing would provide a lower cost of capital. – A lower cost of capital would increase firm value.
