Question

If a firm changes its capital structure by decreasing its ratio of debt to equity, does it increase or decrease the percent of the company finance with equity?

Answer 1

The proportion of companys borrowings to equity, the debt-equity ratio is conditioned by capital structure. In order to examine how a firm's value is affected by changing the amount of leverage, only capital restructurings are considered while the left hand side remains constant. The proper mix of equity and debt is to be maintained by the firm to develop a capital structure that will lead to the maximisation of stakeholders wealth.

Equity beta, which is derived from the capital asset pricing model can be used to calculate shareholders required rate of return. For an all equity firm, this rate also represents the cost of capital for its assets. Weighted average cost of capital employed is an appropriate method to define firms value by discounting future cash flows. Since this discount rate and the firms value is negatively correlated, minimising WACC will maximise value and thus also increases the shareholders wealth. Therefore a certain debt-equity ratio which results in the lowest possible WACC appears to be the optimum capital structure for a firm.

Analysing earnings per share or rate of return on equity is one of the approaches for determining the right mix of capital structure.