Capital structure, weighted average cost of capital, and NPV and IRR capital budgeting concepts for introductory corporate finance.
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- Define capital structure.
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The mix of debt and equity financing used by a firm to fund its assets and operations.- What is financial leverage?
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The use of borrowed funds (debt) to increase the potential return on equity investment.- How does increasing debt affect financial leverage?
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Increasing debt increases financial leverage, which amplifies returns to equity holders but also increases financial risk.- Define optimal capital structure.
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The mix of debt and equity that maximizes firm value and minimizes the weighted average cost of capital.- What is the pecking order theory of capital structure?
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A theory suggesting firms prefer to fund investment first with internal funds, then debt, then equity, to minimize signaling costs.- How do agency costs affect capital structure?
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Agency costs of debt and equity create tradeoffs; too much debt increases bankruptcy costs, too much equity dilutes control.- What does Modigliani-Miller Proposition 1 state?
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In a perfect market with no taxes or bankruptcy costs, firm value is independent of its capital structure.- What does Modigliani-Miller Proposition 2 state?
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In a perfect market, the cost of equity increases with the debt-to-equity ratio to offset the benefit of cheaper debt financing.- Define WACC.
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Weighted average cost of capital, the average rate a firm pays to finance its assets, weighted by the proportions of debt and equity.- What are the two main components of WACC?
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Cost of debt and cost of equity, weighted by their respective market values in the capital structure.- What is the cost of equity?
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The required rate of return that equity investors demand as compensation for their investment risk.- How is cost of equity typically estimated?
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Using the Capital Asset Pricing Model: Cost of Equity = Risk-Free Rate + Beta × (Market Risk Premium).- What is the cost of debt in WACC calculation?
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The interest rate the firm pays on its debt, adjusted for the tax deductibility of interest payments.- Why is the cost of debt tax-adjusted in WACC?
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Interest payments are tax-deductible, so the effective cost of debt to the firm is reduced by the tax shield benefit.- Define the tax shield on debt.
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The reduction in taxes paid by the firm due to the deductibility of interest expenses.
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