FI516 A. Here are the basic Definitions that relate to capital structure:
V= Value of Firm
WACC=Weighted average Cost of Capital
FCF= Free Cash Flow rs And rd = Costs of stock and debt wce And wd = percentages of the firm that are financed with stock and debt
Impact of capital structure is based upon the value of the effect that the debt have on the Weighted Average Cost of Capital and/or the Free Cash Flow. The debt holders, compared to the stockholders, have prior claim on cash flow. The residual claim of stockholders increases the risk when the debt holders fixed claim increases, which in turn causes the stock to go up. Debt also increases the risk of bankruptcy to the company. This causes pre-taxed cost of debt to go up as well. Free Cash flow is also affected by additional debt. This can cause increase in the possibility of bankruptcy as well. An indirect cost would be a loss of customer, as a direct cost of distress would be legal fees. The indirect costs cause NOPAT to decrease. This is caused by the loss of customers, in turn causing the net operating working capital to increase.
The effect that the managers have (or their behavior in most cases) is also effected by additional debt to the company. Managers will be come less likely to spend or waste their Free Cash Flow on opportunities that might in fact add value, or not add value and even the lack of risk in involving the company in any NPV projects that could indeed become prosperous for the company.
B.1. The uncertainty about EBIT is considered to be the business risk. There are many factors that are influential to business risk. Some include: Uncertainty in input costs, and product and other liability types.
B.2. The change in EBIT is known as the Operating Leverage which is caused by the change in the quantity that is sold. With the higher proportion of fixed costs that is inside