Understanding the impact of debt in the capital structure Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key issues related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have made some mistakes. Review the list and identify which items are correct. Check all that apply. Workshop Talking Points An increase in debt financing beyond a certain point is likely to increase the firm's cost of equity. An increase in debt financing decreases the risk of bankruptcy. An increase in the risk of bankruptcy is likely to reduce a firm's free cash flows in the future. Risks of bankruptcy increase management spending on perquisites and increase agency costs. The pretax cost of debt increases as a firm's risk of bankruptcy increases.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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**Understanding the Impact of Debt in the Capital Structure**
Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key issues related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have made some mistakes.
Review the list and identify which items are **correct**. Check all that apply.
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**Workshop Talking Points**
- [ ] An increase in debt financing beyond a certain point is likely to increase the firm’s cost of equity.
- [ ] An increase in debt financing decreases the risk of bankruptcy.
- [ ] An increase in the risk of bankruptcy is likely to reduce a firm’s free cash flows in the future.
- [ ] Risks of bankruptcy increase management spending on perquisites and increase agency costs.
- [ ] The pretax cost of debt increases as a firm’s risk of bankruptcy increases.
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