Capital Structure Considerations

Cost of Capital Considerations

One of the major considerations that firm overseers must take into account when planning their capital structure is the cost of capital.

The expected return on an asset is compared to the cost of capital to invest in it. The cost of capital is an important way of determining whether or not a firm is a worthwhile investment.

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. A company's securities typically include both debt and equity, so one must, therefore, calculate both the cost of debt and the cost of equity to determine a company's cost of capital. The weighted average cost of capital multiplies the cost of each security by the percentage of total capital taken up by the particular security. Then, the results from each security unit are added to the total capital of the company.

If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same.

Because of tax advantages on debt issuance, such as deducting interest payments from taxable income, it will be cheaper to issue debt rather than new equity. At some point, however, the cost of issuing new debt will be greater than that of issuing new equity. This is because adding debt increases the default risk and, thus, the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock). Management must identify the "optimal mix" of financing–the capital structure where the cost of capital is minimized so that the firm's value can be maximized.