Question

Discuss any ways that you think a change in the capital structure of a firm can affect the stock price.

Discuss how the tax code favors debt financing over equity.

Answer 1

1]

Yes, the capital structure of a firm can affect the stock price.

Stock price is derived from the value of the firm. The value of the firm is the present value of its cash flows, discounted at the cost of capital. The cost of capital is the weighted average of each of its sources of capital (bonds, common stock and preferred stock). Hence, changes in the capital structure affect the cost of capital, which affects the firm value and stock price. Higher the cost of capital, lower the firm value and stock price. Lower the cost of capital, higher the firm value and stock price.

2]

The interest payments on debt are tax-deductible, whereas the dividend payments on equity are not tax-deductible. Thus, from a tax code perspective, debt financing has an advantage.