Market Value of the Firm, Market Value of Equity, Return Rate on Capital and the Optimal Capital Structure

Abstract

The firm should pursue both maximum return rate on capital and maximum return rate on equity simultaneously. Maximum return rate on capital is the primary goal for firms because maximum return rate on capital guarantees efficiency. Therefore, maximum profit, maximum market value of the firm, maximum value of equity and maximum return rate on equity are inappropriate to be the primary goal. Since gross profit is independent of capital structure, capital structure just distributes return on capital into equity and debt (i.e., maximum return rate on equity determines capital structure). The maximum return rate on equity is the secondary goal that the firm pursues. Leverage makes the return rate on equity be higher than interest rate. Leverage explains the puzzle of equity premium.