question archive How can optimal capital structure affect WACC and stock price?
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How can optimal capital structure affect WACC and stock price?
Optimal structure is referred to as the point where in the firm's WACC is minimized and the stock price is the maximum at this point. The cost of debt as well as the cost of equity rise with increase in financial leverage ; however the WACC falls in the early additions due to the average of high cost of equity and low cost of debt. The intersection of the marginal cost of capital and WACC is where the optimal capital structure exists. The stock price of a firm initially starts to rise with increase in financial leverage upto a point and then declines at a point where the WACC is minimum. The lower the average cost of capital, the present value of the cash flows increases which thereby increases the stock price.