Question

1. What determines the firm’s optimal capital structure?
2. What risk does beta measure?
3. What is the relationship between the WACC and IRR?

Answer 1

Optimal capital structure is the right mix of debt and equity such that the cost of capital of WACC is minimized. Having only equity in the capital structure can be too costly, so adding debt to the capital structure which has interest tax benefit would decrease the cost of capital. However adding too much debt can increase the cost of distress thus increasing both cost of debt as well as equity , so an optimal mix is always preferred.

Beta is the measure of systematic risk or market risk of a firm. This kind of risk cannot be diversified. Beta is calculated by regressing the stick returns against the market returns and finding the slope parameter.

IRR is the WACC at which NPV is equal to zero. When NPV is positive , the project provides a return greater than the cost of capital. When the cost of capital is increased such that the NPV just becomes negative, this is the internal rate of return of the project or firm.