Can anyone help me with Damodaran's Optimal Capital Structure explanation? When moving to an optimal WACC by increasing debt, an increase in Firm Value is achieved. However, the increased debt amount seems higher than any increase in Firm Value derived from a lower WACC. Doesn't this result in a lower overall equity value? I can't seem to justify the increased value with an even larger increase in debt.

Question

Can anyone help me with Damodaran's Optimal Capital Structure explanation? When moving to an optimal WACC by increasing debt, an increase in Firm Value is achieved.  However, the increased debt amount seems higher than any increase in Firm Value derived from a lower WACC.  Doesn't this result in a lower overall equity value? I can't seem to justify the increased value with an even larger increase in debt.

anonymous · Answer

A Clinic has obtained the following estimates for its costs of debt and equity at various capital structures:

Percent Debt	After Tax Cost of Debt	Cost of Equity
		
0 %	-	16 %
20	6.6 %	17
40	7.8	19
60	10.2	22
80	14.0	27

What is the firm’s optimal capital Structure? (Hint: Calculate its corporate cost of capital at each structure. Also, note that data on component cost at alternative capital structure are not reliable in real world situation).

anonymous · Answer

40% debt would appear to provide the lowest WACC and if we assume a constant Return on Capital employed for any capital stucture, then the value creation (ROCE-WACC) is greater. The Firm Value should be equal to the Equity Value + Debt Value also, it is not the Equity Value. Does it make sense?