Solution
Option 1 -> 100% equity financing increases the weighted average cost of capital (WACC) as equity is more expensive than debt, making it suboptimal.
Option 2 -> 100% debt financing maximizes financial risk, increases probability of bankruptcy, and makes the capital structure unsustainable and extremely risky.
Option 3 -> An optimal mix of debt and equity balances the tax benefits of debt with financial risk, minimizing WACC and maximizing firm value.
Option 4 -> A fixed 50-50 ratio is arbitrary and ignores company-specific factors like industry, growth stage, and risk tolerance that determine optimal structure.
Hence, Option 3: A mix of debt and equity to minimize cost of capital -> The optimal capital structure theory suggests that firms should balance debt and equity to achieve the lowest weighted average cost of capital (WACC). This approach leverages the tax shield benefits of debt while avoiding excessive financial risk, ultimately maximizing shareholder value. The exact proportion varies by company based on factors like industry norms, business risk, and growth prospects. -> correct
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