Capital Structure and the Cost of Capital

In Chapter 15, we discussed the concept of the firm's weighted average cost of capital, or WACC. You may recall that the WACC tells us that the firm's overall cost of capital is a weighted average of the costs of the various components of the firm's capital structure. When we described the WACC, we took the firm's capital structure as given. Thus, one important issue that we will want to explore in this chapter is what happens to the cost of capital when we vary the amount of debt financing, or the debt-equity ratio.

A primary reason for studying the WACC is that the value of the firm is maximized when the WACC is minimized. To see this, recall that the WACC is the discount rate that is appropriate for the firm's overall cash flows. Because values and discount rates move in opposite directions, minimizing the WACC will maximize the value of the firm's cash flows.

Thus, we will want to choose the firm's capital structure so that the WACC is minimized. For this reason, we will say that one capital structure is better than another if it results in a lower weighted average cost of capital. Further, we say that a particular debt-equity ratio represents the optimal capital structure if it results in the lowest possible WACC. This optimal capital structure is sometimes called the firm's target capital structure as well.

0 0

Post a comment