Answer:
Capital Structure is a combination of all the long term which includes both debt and equity financing. The capital structure theories helps the treasury department of the company to find an optimum capital structure (Mixture of debt and capital) that gives the lowest weighted average cost of capital and this lowest WACC, gives highest value of the company.
Mathematically,
Value of the Company = Future net cash flows / Lowest WACC
The factors that affect WACC can be understood if we have a glance on its formula:
WACC = (Ke * E /(E + D)) + (Kd * D /(E + D)* (1 - Tax))
The reduction in WACC is largely due to increase in the debt because it gives tax benefits and this lowers the WACC.
To arrive at the lowest WACC, Tom Moore will consider all of the following factors:
- Future Net Cash Flows: If the company is earning more than before then this will increase the value of the company because debt terms and conditions would be bargained at a better position and all this is possible if stable cash flow position has been achieved by the company. This means that the debt would be raised at a cheaper rate that will also lower WACC and increase Future Net cash flows.
- Debt to Equity ratio: This factor helps in determining how much the company must borrow in order to gain the maximum benefit of the debt. On the other hand, the finance raising cost of debt will also increase which means raising finance will become difficult.
- Matching Concept: The finance required must be matched with the time duration it is necessary. This means that the long term investments must be financed with long term finance and short term needs must be financed by short term finance. This will help the company to lower its cost paying commitments to lenders and investors.
- Other Factors: These are the factors that affects the management of Capital structure which includes market conditions, tax rate, credit rating, industry related risk, economy future projection, etc, all these factors have minute impact on the fund raising and are an obstacle to achieve optimal capital structure.
