Back to: Financial Management
Hello, students!
Today we are delving into a crucial area of financial decision-making: Capital Structure and Cost of Capital.
These topics are about how businesses decide on the right mix of financing (debt and equity) and the cost involved in using those funds. Ready your pens—we’ll cover some essential theories and calculations.
Lesson Objectives:
By the end of this lesson, students should be able to:
Define capital structure and cost of capital.
Identify the components of capital structure.
Explain the factors affecting capital structure.
Understand the basic concept of cost of capital.
Capital Structure and Cost of Capital
Definition:
Capital structure refers to the combination of different sources of long-term financing used by a company. This typically includes equity, debt, and retained earnings.
Formula Example:
Capital Structure = Equity + Debt + Preference Shares
Components of Capital Structure:
Equity Capital:
Owner’s funds. No repayment obligation, but shareholders expect dividends.
Debt Capital:
Borrowed funds like loans and bonds. Must be repaid with interest.
Preference Shares:
Hybrid form; fixed dividend but less risky than equity.
Factors Affecting Capital Structure:
Cost of capital: Cheaper sources are preferred.
Risk: More debt increases financial risk.
Control: Issuing more equity can dilute ownership.
Cash flow: Ability to meet debt obligations.
Tax: Interest on debt is tax-deductible.
Cost of Capital:
Definition:
The cost of capital is the return expected by those who provide the company with capital. It represents the company’s cost of financing its operations and investments.
Types:
Cost of Equity:
Return expected by shareholders.
Cost of Debt:
Interest paid to lenders, adjusted for tax.
Weighted Average Cost of Capital (WACC):
The overall average cost based on the proportion of each source of finance.
WACC Formula (Simplified):
WACC = (E/V × Re) + (D/V × Rd × (1 – T))
Where:
E = Equity
D = Debt
V = Total Capital (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T = Tax rate
Why Is Capital Structure Important?
Affects the firm’s profitability and value.
Influences investor confidence.
Impacts risk and control levels.
Summary:
Capital structure decisions are about finding the right balance between debt and equity to finance operations. Cost of capital helps determine the best financing mix by comparing the costs and risks of each source. Together, they guide a firm’s long-term strategy.
Class Activity / Discussion:
Case Analysis:
ABC Ltd. wants to expand and is considering raising funds through a bank loan or issuing more shares. In groups, discuss the pros and cons of each option based on cost and control.
Evaluation (Assessment Questions):
What is capital structure?
List and explain two components of capital structure.
What is meant by the cost of capital?
Define WACC in simple terms.
Why might a company prefer debt over equity financing?