Question

How does a firm’s capital structure affect its value? Be sure to discuss the cost of the two primary types of capital and their impact on valuation.

Answer 1

A firm's capital structure affect its value as

and we know WACC is weighted average cost of capital, WACC includes the weight of debt and weight of equity in capital structure.

We see in above formula weight of debt and weight of equity is used and their respective cost to firm is used.

The cost of two primary types of capital are:

• Cost of Debt
• Cost of Equity

Debt comes with tax benefits, more the debt, less the WACC. But when debt increases, the stockholders want more return as firm starts becoming weak in liquidity and solvency terms. Hence, an optimal capital structure is required where cost of debt and cost of equity are minimum which minimizes the WACC and maximizes the value of firm.