1- Explain is theCapital structure theory 2- Explain what is Debt/equity ratio?
ID: 2478647 • Letter: 1
Question
1- Explain is theCapital structure theory2- Explain what is Debt/equity ratio? In your opinion is debt /equity ratio and the capital structure theory are ihelpful or not for the firm? 1- Explain is theCapital structure theory
2- Explain what is Debt/equity ratio? In your opinion is debt /equity ratio and the capital structure theory are ihelpful or not for the firm?
2- Explain what is Debt/equity ratio? In your opinion is debt /equity ratio and the capital structure theory are ihelpful or not for the firm?
Explanation / Answer
(1) Capital structure theory visits the optimum proportion of debt and equity that results in lowest weighted average cost of capital (WACC). Equity is the costliest source of capital and higher proportion of equity results in higher WACC. Interest on debt being tax-deductible, debt is a cheaper form of capital, but if employed at a high proportion, leverage increases, raising the firm's risk. So, after a threshold, higher debt raises WACC. The capital structure theory aims to find out that point of optimality at which WACC is at its minimum.
(2) Debt/equity ratio measures the proportion of debt to equity in the capital structure.
Debt equity ratio helps understand the magnitude of leverage in a firm. A firm's existing debt/equity ratio determines the WACC and the difference between optimal and existing capital structure, so both these concepts are useful to the firm.
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