Question 8.RQ.4: What are the main implications for the financial manager who...

An important implication of (a), the traditional approach, is that financial managers should try to establish the mix of loan/share finance that will minimise the overall cost of capital. At this point, the business will be said to achieve an optimal capital structure. Minimising the overall cost of capital in this way will maximise the value of the business. An important implication of (b), the MM (excluding tax effects) approach, is that the financing decision is not really important. As the overall cost of capital remains constant, a business does not have an optimal capital structure as suggested by the traditionalists. This means that one particular capital structure is no better or worse than any other and so managers should not spend time evaluating different forms of financing the business. Instead, they should concentrate their efforts on evaluating and managing the investments of the business. However, (c), the MM (including tax effects) approach, recognises that the tax shield on loan capital benefits the ordinary shareholders and the higher the level of interest payments, the greater the benefits. The implications of this approach are that there is an optimal capital structure (and in that sense it is similar to the traditional approach) and that the optimal structure is a gearing ratio of 100 per cent.