Question

A firm's WACC is affected by its capital structure, read and summarize one of the capital structure theories presented in section 2 of the article titled "Capital Structure Theroy: An Overview". Use at least 100 words to discuss how does it relate to WACC and the firm value maximization.

Answer 1

WACC stands for weighted average cost of capital. Each category of capital is proportionally weighted.

WACC Formula and Calculation

WACC=EV∗Re+DV∗Rd∗(1−Tc)

where:

Re = Cost of equity

Rd = Cost of debt

E = Market value of the firm’s equity

D = Market value of the firm’s debt

V = E + D = Total market value of the firm’s financing

E/V = Percentage of financing that is equity

D/V = Percentage of financing that is debt

Tc = Corporate tax rate​

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost.

However, there is a limit to the amount of debt a company should have because an excessive amount of debt increases interest payments, the volatility of earnings, and the risk of bankruptcy. This increase in the financial risk to shareholders means that they will require a greater return to compensate them, which increases the WACC—and lowers the market value of a business. Since debt is tax deductible, firms can use it as an effective way to reduce the WACC. However, as the total debt of the firm increases, the financial burden and the rate at which firm can borrow in the future increases which in return increases their WACC. The optimal structure involves using enough equity to mitigate the risk of being unable to pay back the debt—taking into account the variability of the business’s cash flow.