Capital structure is the way a business has elected to finance the assets it needs for operations. The two ways it can do this are through:
There can also be hybrid securities in the capitalization which have characteristics of both equity and debt, such as preferred stock.
One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that the capital could be expected to earn on another investment with the same risk.
Suppose a company has $140 million in total debt and $50 million in total equity. The coupon payment for the cost of debt is 6% and the required rate of return from the market on the equity is 8%. The corporate tax rate of 40% also needs to be taken into account because the interest payments on our bonds (the debt) are tax-deductible for corporate taxes.
What is the weighted average cost of capital for this company?
Weighted Average Cost of Capital Calculator Total Debt (D) 140 Total Equity (E) 50 Cost of Debt (Rd) 6% Cost of Equity (Re) 8% Corporate Tax Rate (Tc) 40% Weighted Average Cost of Capital (WACC) 4.758%
Using a web app that calculates the weighted average cost of capital, we find the WACC to be 4.758% – so, less than 5%.
This brings the question to management of how much of the capitalization should be equity and how much should be debt. The fact that debt interest paid is not taxable is a tendency to favor debt. However, the amount of leverage through debt could increase to the point where risk increases the required rate of return on the debt. So, the decision rests on focusing on this trade-off when choosing how much debt and how much equity should be used in capitalization.
It is reasonable to think the firms would use much more debt than they actually do in reality. The reason they do not is because of the risk of bankruptcy and the volatility that can be found in the credit markets. This volatility increases, particularly when a company tries to take on too much debt.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Capital Structure Considerations” TUTORIAL.