Alicja Nowak-Igwe
ID D03509235
FI 516 Advance Managerial Finance

Mini Case

a) Provide a brief overview of capital structure effects. Identify the ways in which capital structure can affect the WACC and FCF.
Capital structure presents how a company finance its operations. It is expressed as percentage of debt, preferred stock, common equity used in financing a company's operations.[1]
WACC calculates a company's “cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation.”[2] “WACC depends on percentage of debt and common equity (wd) and (ws), the cost of debt (rd) and cost of stock (rs ) and the corporate tax rate (T)”.[3]
WACC = wd(1 – T)rd + wsrs
The effect of debt on WACC and Free Cash Flow is influenced by impact of the capital structure on value.[4]
Capital structure affects the WACC and FCF of a company in many ways. The debt holders have a right to a cash flow before shareholders, which means that dividend can't be paid out unless all obligations toward debt holders for the specific period of time are met. Because of that, the cost of stock, rs goes up.[5]
A high debt increases the risk of bankruptcy for a company, which might able to meet all payments. This risk of bankruptcy causes pre-tax cost of debt, rd, to increase.[6] In addition, increased risk of bankruptcy reduces ed free cash flow, which can be affected by legal costs of bankruptcy, “short sale” of assets, as well as decrease in sales, lost of customers, loss or reduction of credit line, decreased productivity of employees and managers who might feel need to “abandon the sinking ship”.[7]
A positive effect of debt is that a company can deduct the interest expenses which allows to pay smaller taxes and at the same time allow a company