Capital Structure Theory Essay

1198 Words5 Pages
Caleb Johnson
Capital Structure Theory
Working Capital Management
Dr. Woodward
10/14/14
Capital Structure Theory
Part a. (Capital Structure) Capital structure is very important. Not only does it influence the return a company earns for its shareholders but can also be a determining factor on whether or not a firm survives a recession. A company’s capital structure is a mix of their short-term debt, long-term debt, and equity. A firm’s capital structure is the way the firm finances all of its operations, investments, and growth. When a firm’s debt-to-equity ratio maximizes its value and minimizes the firm’s weighted average cost of capital (WACC), it is said to be at the “target” or “optimal capital structure”. Debt usually offers
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Because of signaling, when a firm tries to adjust their capital structure their investors behave in a way directed by the signal given, whether that signal is accurate or not.
Part f. (WACC) WACC or weighted average cost of capital is the firm’s cost of capital with each category of capital weighted proportionately. The more debt that company uses, the higher the WACC. The higher the WACC, the higher the company’s risk. When using debt, the WACC begins to fall, but eventually, the costs of debt and equity will cause WACC to increase which will in turn cause the value of the company to drop. This brings us back to the optimal or target capital structure, where the debt to equity ratio maximizes the firm’s value.
Part g. (Reserve Borrowing Capacity) Firms should however, use a lower debt to equity ratio than optimal capital structure suggests. The reason being, that an opportunity may arise where more funds are needed. As previously discussed, the issue of more stock sends a negative signal whether the signal is accurate or not, but to issue more debt past the optimal capital structure ratio would decrease the firm’s value which would also send a negative signal. Therefore, a firm should have a reserve borrowing capacity in the case of such an opportunity.
Part h. (Windows of Opportunity) A window of opportunity is a time period where a normally unreachable opening exists. An example is today’s interest rates. The windows of opportunity
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