Question

What are the most relevant considerations in determing what a firm's ideal capital structure is (Define WACC and Modigliani-Miller theorem in your answer) 3-4 paragraphs

Answer 1

The capital structure of a firm consists of two main components i.e. debt and equity. A firm tries to maintain balance between the debt and equity component of the capital structure. The debt helps is getting tax benefit on the interest paid while the equity does not give any such benefit. The equity in fact leads to sharing of the ownership rights of the company.

WACC or Weighted Average Cost of Capital is the average rate of return that the company expects to earn on the investment. The calculation is done based on the weightage of that component of the capital structure and the return that it is expecting to earn. It includes common stock, preferred stock, retained earnings, bonds etc.

The ideal capital structure is the one that gives the maximum benefit to the company. The final goal of the company is to maximize the shareholders wealth. This wil be reflected in the form of the stock price.

The Modigliani-Miller approach however, states that the value of the firm whether it is leveraged or unleveraged, is the same. This means that no matter whether the company has only debt or only equity or a combination of debt and equity in its capital structure, the value of the firm will remain the same. Instead, the theory states that the value of the firm will depend on the growth prospects of the firm.