Question

What are some ways in which the capital structure decisions can affect the value of operations?

Answer 1

The value of operations is the present value of a future cash flows, discounted at the WACC

That is, the value of operations is the sum total of projected future cash flows, discounted back to the present using WACC as the discount rate.

WACC is affected by capital structure decisions. WACC is the weighted average return required by the suppliers of capital (commons stock, preferred stock and debt) on their investment in the firm. The return required by each source of capital is weighted against its proportion in the capital structure.

For example, the decision to take on more debt (a capital structure decision) would decrease the WACC upto a certain extent. This is because debt is usually cheaper than equity. This would increase the value of operations as the discount rate is decreasing. However, after a certain point, the proportion of debt in the capital structure may be too high, which increases the risk of debt investors. This risk is due to risk of leverage and risk of default. This would increase the WACC, and the value of operations would decrease.

On the other hand, if there is a decision to have no debt, the WACC would be high since the cheaper source of capital (debt) is not used. This would decrease the value of operations