CAPITAL STRUCTURE & COST OF CAPITAL

Capital Structure & Cost of Capital



Capital Structure & Cost of Capital

In order to evaluate any company from investment point of view, one of the fundamental element of consideration is company's balance sheet with in which an investor can assess the capital structure and resolve is the company good for investment or not. Capital structure represents how the company management has decided to finance the operations and capital expenditure for long term growth and development. Funding can be done either through equity or debt. Equity represents the shareholders contribution in the company financing while liabilities are external source of funding for the company.

The main objective of any organization is to maximize the shareholder's health. The determination of capital structure, that is the percentage of debt and equity, is one of the most critical decisions in this regard. Theoretically, the optimal capital structure is at the point where the share price of the company is maximum and weighted average cost of capital is minimum. However, the determination of capital structure highly depends upon the nature of the company and cost of capital. Companies with the high cost of debt and leverage are recommended to move towards equity issuance. Debt equity ratio is the tool to measure the percentage of debt over equity. It is calculated by dividing the total liabilities over total equity (Baker, 2002).

Importance of Capital Structure

Financing decisions are crucial for every organization. These decisions are related with the means in which company manage and obtain long-term financing to obtain and preserve their prolific assets. There are two principal sources of funds: equity and debt. Every company has some equity as equity signifies ownership in the company. It comprises of capital contributions by the owners and also retained earnings of the company that have been reinvested. In addition, most firms opt for debt financing to meet the necessities of the business. Debt financing can be defined as a method through which businesses borrow in order to raise capital for its operations. One of the sources of Long-term financing is long-term liabilities consisting mainly of the Bonds. Bonds are long term contracts under which a borrower agrees to make payment of interest and principal on specific dates to the bondholder, at a fixed rate that is predetermined. Most bonds are issued with maturities of 5 to 30 years.

Determinants of capital structure

The theories of the firm have been deeply enriched with the works of MM (1958) which showed that the choice of capital structure has no interest because it is neutral on the value of the firm. After forty years of research on this subject, the conceptual framework of MM is now widely recognized in the field of finance. However, the debate is still relevant as there is no universal theory of the structure of capital and there is no reason to expect to see one emerge (Myers 2001). The objective here is not to make an exhaustive literature review of capital structure, the reader ...