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Meaning of capital structure

The amount of debt and/or equity used by a company to fund its operations and finance its assets is
referred to as its capital structure. The capital structure of a company is often described as a debt-to-
equity or debt-to-capital ratio.

Debt and equity capital are used to fund operations, capital expenditures, acquisitions, and other
investments in a corporation. When deciding whether to employ debt or equity to finance
operations, organizations must make choices, and management must balance the two to create the
ideal capital structure.

Optimum capital structure

The ideal capital structure of a corporation is frequently described as the proportion of debt and
equity that results in the firm having the lowest weighted average cost of capital (WACC). In fact, this
technical definition is not always used, and organizations frequently have a strategic or philosophical
vision of what the ideal structure should be.
In order to optimize the structure, a firm can issue either more debt or equity.  The new capital that’s
acquired may be used to invest in new assets or may be used to repurchase debt/equity that’s
currently outstanding, as a form of recapitalization.

Meaning and Definition of Cost of Capital

The role of cost of capital is very important in decision making process of financial management. The
cost of capital is used for two purposes, simultaneously, firstly, a comparison of alternative sources of
funds may be made to select one which has least cost and maximum contribution to wealth
maximisation, secondly, to evaluate Investment proposals, as it provides a benchmark to yield a
minimum return. A few definitions on cost of capital are given below.

Different definitions of Cost of Capital

1. Cost of capital is a cut-off rate for the allocation of capital to investments of projects. It is the
rate of return on a project that will leave un-changed the market price of the stock.

2. The cost of capital is the rate of return a firm must earn on its investments for the market
value of the firm to remain unchanged. It can also be thought of as the rate of return
required by the market suppliers of capital in order to attract needed financing at a
reasonable price.

3. The cost of capital is the rate that the firm has to pay, explicitly or implicitly, to investors for
their capital or the minimum rate of return required by the suppliers of capital, thus, ignoring
taxes and flotation costs, the cost of capital represents two sides of the same coin — the cost
to issuers is the return for investors".

4. The project's cost of capital is the minimum required rate of return on funds committed to
the project, which depends on the riskiness of its cash flows”.

5. Cost of capital is the expected return available on securities with equivalent risk and term to
a particular investment”.

6. Cost of capital may be defined as the rate of that must be earned on the net proceeds to
provide the cost elements of the burden at the time, they are due”.

7. Cost of capital is the rate of return the firm requires from investment in order to increase the
value of the firm in the market place”.

Characteristics of the cost of capital

1. Cost of capital is a rate of return, generally, expressed in percent value.

2. It is the minimum required rate of return to offset the affect of risk associated
with business, and to maintain profitability in order to maximise the wealth of
shareholders

3. Cost of capital has role in maintaining market value of the firm. The value of a firm will decline if a
firm uses capital at a higher cost than its return on assets.

4. Arranging source of finance at rate of return (called cost of capital), and allocating them in
investments are the two sides of same coin. The amount so invested must yield return equal to or
more than a rate at which sources are arranged to fund such vestments.

5. Cost of capital involves implicit as well as explicit cost, therefore, it takes future risk and business
risk into account.

Formula and components of cost of Capital

The cost of capital may be put in the form of the following equation:
K = ro + b + f

Where
-K = Cost of Capital
-ro = Return at Zero Risk Level
-b = Premium for Business Risk
-f = Premium for Financial Risk

Cost of capital consists of three components :

1. Return at Zero Risk Level. (r0)
2. Premium for Business Risk (b)
3. Premium for Financial Risk (f)

A firm's cost of capital has mainly three risks

a. Return at Zero Risk Level : This refers to the expected rate of return when a project involves
no risk whether business or financial.
b. Premium for Business Risk : Business risk is possibility where in the firm will not be able to
operate successfully in the market. Greater the business risk, the higher will be the cost of
capital.
c. Premium for Financial Risk : It refers to the risk on account of pattern of capital structure. In
other words, a firm having a higher debt content in its capital structure is more risky as
compared to a firm which has a comparatively low debt content.

Importance
1. Cost of Capital and Financial Decisions: Cost of capital has more usages in financial decision
making, e.g., in valuation of retained earnings, dividend policy, capitalization or profit also.
Cost of capital involves business risk as well as financial risk, therefore, it recognises the time
value of money in optimum manner. Moreover, cost of capital also takes explicit and implicit
cost into account, thus, opportunity cost is also considered in financial decision
making when the decision is taken on the basis of cost of capital.

2. Cost of Capital in Capital Budgeting: The cost capital is the fundamental requirement of
capital budgeting technique especially based on discounted cash flows. The acceptance and
rejection of a proposal depends upon cost of capital associated with it. A proposal with
higher rate of return have lesser net present value in comparison of another proposal with
lesser cost of capital, therefore, more chances to reject the proposal with higher cost of
capital. Since, the cost of capital represents to minimum rate of return to be earned on an
investment, thus, a costly source of finance expects higher rate of return from assets to
be funded from such source of finance. Net present value, profitability index,
discounted payback period method and many more are based on cost of capital
to discount the cash flows. Hence, the cost of capital 1s very useful in capital
budgeting decision.

3. Cost of capital helps in evaluation of performance of top management

4. Cost of Capital in Determination of Capital Structure : Every source of fund has own features,
few are costly in comparison of others, some are easily available etc. A firm, commonly, uses
both equity and debt as a mix in its total financing. The cost of debt 1s considered at lower
rate in comparison to equity. At the same, there 1s tax advantage on debt security but not on
equity capital. Therefore, an optimum mix of debt and equity 1s helpful in determination of
average cost of capital. In designing an optimal capital structure, the management has to
keep in mind the objective of maximising the value of the firm which makes cost of capital
important in financial planning of the firm.