The following statement is true. But I did not understand what is optimal debt ratio and how it is related to business reisk. Could you please explain. The greater a company’s business risk, the lower its optimal debt ratio.
This is what I think…The appetite for risk by investors is finite. The measure of risk a stock investor is interested is …is the variability of EPS. EPS i.e. net Income This risk can be broken down into either business risk i.e variability of sales, operationg leverage (EBIT) etc or Financial risk…risks inherent in the balancesheet due to the choice of financial structure (debt to equity ratio, interest coverage etc.) If a company’s business risk is high, you do not want to compound that by taking higher financial risk, thus you would want your financial risks to be low…one way to do that is to have a lower debt.
Optimal debt ratio is the ideal combination of debt in the firm’s overall capital structure. If business risk is high, then increasing the level of debt will only lead to increased business risk. A lower optimal debt ratio will decrease the overall business risk to the firm.
WACC as a function of debt-to-cap generally exhibits a minimum point. How does this happen? While increasing D/C increases the weight of (lower-cost) debt and tax shield, in increases the cost of equity (since the relative volatility of equity increases as debt increases). At higher debt levels, eventually the increase in cost of equity outweighs the benefits of increased debt, and wacc begins increasing. The more the inherent business risk in a firm, the earlier this point is reached.