Question

Only looking for Part G to be answered - thank you!

3.A. Explain what is meant by the capital structure of an industrial firm (such as a manufacturing company). Be precise.

B. List components of the capital structure that you have defined above.

C. Are the items you have listed in part B above long term in nature (more than one year?)

D. Explain (in as much detail that you wish, including numerical analysis and graphs) the net income view or the traditional approach in regards to the relationship between the WACC and the value of the firm.

E. Explain (in 5 lines) why you would agree with the net income approach as listed in part D above.

F. Explain (in as much detail that you wish including numerical analysis and graphs) the operating income view or the neo-classical approach in regards to the relationship between the WACC and the value of the firm.

G. Explain (in 5 lines) why you would agree with the operating income or the neo-classical approach as listed in part D above.

Answer 1

The value of the firm is a function of the weighted average cost of capital. So the capital structure plays a role in deciding the value of the firm. If the firm is fully equity financed, then it is not an optimal structure as the firm is not taking advantage of the tax shield available from debt financing. Similarly if the firm is fully leveraged and debt financed only, then the cost of debt would go up prohibitively high due to the higher risk of default that the firm is facing.

So in between these two extremes, there is an optimal mix of debt and equity which minimizes the cost of capital of the firm and maximizes firm value.

So this is what is explained by the relationship between WACC and the value of the firm.