Question

How does capital structure play a role in a firm's project decision?

Answer 1

How does capital structure play a role in a firm's project decision?

The decision whether to accept a project or reject a project is based on the Net Present Value (NPV) of the project.

The net present value is found by discounting the firm's cash flows using a discount rate. That discount rate is the firm's Weighted Average Cost of Capital (WACC).

WACC is determined using the above equation.

D and E are the amount of Debt and Equity, respectively. The amount of Debt and Equity in the firm's capital is called the capital structure.

So, by changing the firms Debt and Equity (capital structure), WACC can be changed. By changing WACC, the NPV of the project is changed and hence the decision of accepting or rejecting the project.