Final answer:
The capital structure decision affects WACC and FCF. Debt financing increases WACC but can also reduce after-tax cost of debt. Equity financing increases cost of equity. Optimal capital structure is determined by analyzing factors such as risk, industry norms, and cost of capital.
Step-by-step explanation:
The capital structure decision can impact the Weighted Average Cost of Capital (WACC) and Free Cash Flow (FCF) of a firm.
When a firm uses debt financing, it incurs interest expenses which increase its cost of capital. As a result, WACC increases. However, debt financing can also lead to tax benefits which reduce the after-tax cost of debt and overall WACC.
On the other hand, equity financing does not have interest expenses but requires a higher rate of return for shareholders which can increase the cost of equity and the overall WACC.
Regarding Free Cash Flow (FCF), the capital structure decision can affect the amount of cash available for investment. A firm with a higher proportion of debt may have lower FCF as it needs to dedicate more cash flow towards interest payments. In contrast, a firm with a higher proportion of equity may have higher FCF as it does not have interest obligations.
The process of identifying the optimal capital structure involves analyzing various factors such as the firm's risk profile, industry norms, tax environment, and cost of capital associated with different sources of financing. The goal is to find the capital structure that minimizes the overall cost of capital and maximizes the value of the firm.