Capital Structure Considerations

How do businesses benefit from using capital structure, optimal capital structure, debt and equity, and return on investment? Businesses have the opportunity to earn more return from their investments and their blend of debt and equity capital structure. This section gives examples of how these concepts are used.

Cost of Capital Considerations

Cost of capital is important in deciding how a company will structure its capital so to receive the highest possible return on investment.


LEARNING OBJECTIVE

  • Describe the influence of a company's cost of capital on its capital structure and investment decisions

KEY POINTS

    • 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 capital could be expected to earn in an alternative investment of equivalent risk.
    • Once cost of debt and cost of equity have been determined, their blend, the weighted average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cash flows.
    • The weighted average cost of capital multiplies the cost of each security (debt or equity) by the percentage of total capital taken up by the particular security, and then adds up the results from each security involved in the total capital of the company.

TERMS

  • cost of preferred stock

    the additional premium paid to have an equity security with certain additional features not present in common stock

  • capital rationing

    restrictions on how or how much a company can invest

  • cost of capital

    The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.

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


The expected return on an asset is compared to the cost of capital to invest in the asset: 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, and then adds up the results from each security involved in 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 the ability to deduct 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 the cost 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.