The investors who invest their money in the firm for hope to get a return on their investment are called stockholders or shareholders. In other words, evaluation of a proposed project should be based on the project's cost of capital (Vernimmen, 2005). This is because when a company raises capital, there is usually no direct links between the return to the supplier of the company's capital and the return on individual project. The corporation then uses the weighted average of these capitals for mixing in the firm's overall equity to analyze the capital budgeting decisions. It takes into consideration the weighted average of all the capital and is thus referred as weighted average cost of capital (WACC).
The firm's mixture of debt and equity is called its capital expenditure. Although actual level of debt and equity may vary somewhat over time, most firms try to keep their financing mix close to a target capital structure. As we know that the WACC is a weighted average of relatively low-cost debt and high cost equity, so precisely we can say that capital structure change will affect the WACC to increase or decrease with respect to the change that occurs in the capital structure.
The firm's mixture of debt and equity is called its capital structure. ...
ecisely we can say that capital structure change will affect the WACC to increase or decrease with respect to the change that occurs in the capital structure.
OPTIMAL CAPITAL STRUCTURE:
The firm's mixture of debt and equity is called its capital structure. The fundamental source of a company's value is the stream of net cash flows generated by it assets. This stream is usually referred to as the company's net operating cash flow or earning before interest and taxes (EBIT). The capital structure adopted by a company divides the stream between different classes of investors. If a company is financed entirely by equity and there is no company tax, this entire stream is available to provide income to shareholders. If a company also borrows funds, the lenders have the first claim on the net operating cash flow and shareholders are entitled to the riskier, residual cash flow that remains after the lenders have been paid (Vernimmen, 2005). Manager should choose the capital structure that maximizes shareholder's wealth. The basic approach is to consider a trial capital structure based on the market values of the debt and equity, and then estimate the wealth of the shareholders under this capital structure. This approach is repeated until an optimal capital structure is identified.
We have to take 5 steps into consideration to determine an "optimal capital structure", the steps are;
1. Estimate the interest rate the firm will pay
2. Estimate the cost of equity
3. Estimate the weighted average cost of capital (WACC)
4. Estimate the free cash flow and their present value, which is the value of the firm
5. Deduct the value of the debt to find the shareholders' wealth which we want to maximize
An investor in a company with a low debt-equity ratio is likely to attach a low