Capital Structure Theory Essay

Topics: Finance, Weighted average cost of capital, Corporate finance Pages: 4 (1209 words) Published: November 12, 2014
Caleb Johnson
Capital Structure Theory
Working Capital Management
Dr. Woodward
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 a lower cost of capital because of the ability to deduct tax from interest, but the company’s risk increases as debt increases. Part b. (Business Risk)

Business risk refers to the risk brought upon the firm by its operations. This can be influenced by many factors such as, cost of production, sales volume, unit price, competition, demand, government regulations, etc. A company with higher business risk should operate with a capital structure that has a lower debt ration to safeguard its shareholders by guaranteeing that it can meet all of its financial obligations. A high business risk means a low debt ratio while a low business risk means that a firm might be able to operate with a high debt ratio. Part c. (Operation Leverage)

A firm that makes few sales with sales providing a high gross margin is said to have high operation leverage. Operating leverage is dependent on a firm’s fixed and variable costs. If a firm has a high proportion of fixed costs it has high operation leverage as opposed to a firm with low fixed costs and high variable casts which are considered to have a low operation leverage. A high-end car dealership has high operating leverage while a grocery store has low operating leverage. In a...
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