Question

Explain why the capital structure of a firm is irrelevant to equity investors.

Answer 1

Capital structure of a firm is irrelevant to the equity investor because capital structure of a firm will not be affecting the investors cash flow opportunities and these capital structure decisions are always readjustment of debt and equity capital and there are no changes in the earning capacity of the average equity investor due to change in the capital structure of the company.

It is always believed that there will be an equilibrium between optimum earnings and optimum capital structure and investors who are equity shareholders will generally not be affected much by changes into the capital structure of the company.

if we are going to consider the real life example, then we should emphasize that when the Dividend or interest are paid to the various share holders and debt holders according to the capital structure of the company that will not be impacting the repayment ability of the company in the real world to a higher extent and investors capacity to earn is also not affected due to change in the capital structure.

It can always be said that the cash flows which are accrued to the investors are not affected by the debt holders because interest paymentsyto these debt holders are generally not accounted into the cash flows and they are treated as non operating cost so it can also be said that since there is an irrelevance of interest cost into the overall cash flows the investors cash flows are not affected and change in capital structure would not be bothering the equity investors much.