The optimal debt ratio is the debt ratio that:
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A. B. C. D.Explanation
The optimal debt ratio is defined as the debt level that maximizes the firm's stock price.
The optimal debt ratio refers to the level of debt a firm should have in its capital structure that maximizes its value or stock price. The concept of the optimal debt ratio is based on the trade-off between the benefits and costs associated with debt.
A. The answer choice A states that the optimal debt ratio minimizes the firm's bankruptcy costs. While it is true that excessive debt can increase the risk of bankruptcy, minimizing bankruptcy costs is not the primary objective of determining the optimal debt ratio. Therefore, this answer choice is not correct.
B. The answer choice B states that the optimal debt ratio maximizes the firm's earnings per share (EPS) and maximizes the firm's stock price. This is not entirely accurate. While debt can increase a firm's earnings per share through interest tax shield (i.e., the tax deductibility of interest payments), there is no direct relationship between the optimal debt ratio and maximizing EPS or stock price. Moreover, maximizing EPS may not necessarily lead to maximized stock price. Therefore, this answer choice is also incorrect.
C. The answer choice C states that the optimal debt ratio maximizes the firm's stock price. This is the correct answer. The optimal debt ratio is the level of debt that strikes a balance between the benefits and costs of debt financing, ultimately resulting in the highest stock price. Debt can provide certain advantages, such as tax benefits and increased financial leverage, which can enhance the firm's value and, consequently, its stock price. However, if a firm takes on too much debt, it may face financial distress, higher bankruptcy risk, and increased cost of capital, leading to a decline in stock price. Therefore, the optimal debt ratio is the level of debt that maximizes the firm's stock price.
D. The answer choice D states that the optimal debt ratio maximizes the firm's earnings per share (EPS). As mentioned earlier, while debt can increase EPS through interest tax shield, there is no direct relationship between the optimal debt ratio and maximizing EPS. Therefore, this answer choice is not correct.
To summarize, the optimal debt ratio is the level of debt that maximizes the firm's stock price by striking a balance between the benefits and costs of debt financing. It is not primarily focused on minimizing bankruptcy costs, maximizing EPS, or directly maximizing stock price.