Constrained Cost of Capital Approaches

The cost of capital approach that we have described is unconstrained, since our only objective is to minimize the cost of capital. There are several reasons why a firm may choose not to view the debt ratio that emerges from this analysis as optimal. First, the firm's default risk at the point at which the cost of capital is minimized may be high enough to put the firm's survival at jeopardy. Stated in terms of bond ratings, the firm may have a below-investment grade rating. Second, the assumption that the operating income is unaffected by the bond rating is a key one. If the operating income declines as default risk increases, the value of the firm may not be maximized where the cost of capital is minimized. Third, the optimal debt ratio was computed using the operating income from the most recent financial year. To the extent that operating income is volatile and can decline, firms may want to curtail their borrowing. In this section, we will consider ways in which we can bring each of these considerations into the cost of capital analysis.

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