Capital Structure and Cost of Capital
Capital Structure is the specific mix of long-term debt and equity used by a company. Debt refers to borrowed money, such as bank loans or bonds. Equity refers to the owner's money or shares. A company needs to find the best balance between these two sources. This balance is called the 'Optimal Capital Structure.' The main goal is to maximize the value of the firm. It also aims to minimize the overall cost of capital. Every source of money has a cost.
Concepts (3)
Financial leverage is the use of fixed-cost debt to increase potential returns. It is often called 'Trading on Equity.' If a company earns more on its assets than the interest rate on its debt, the leverage is positive.
Financial leverage is the use of fixed-cost debt to increase potential returns. It is often called 'Trading on Equity.' If a company earns more on its assets than the interest rate on its debt, the leverage is positive. For example, if a bank borrows at 6% and invests at 10%, the extra 4% belongs to the owners. However, if the investment returns only 4%, the company still owes 6% interest. This leads to a loss. It measures the financial risk of a company.
The cost of debt is the effective interest rate a company pays on its borrowings. In India, interest paid on loans is an expense before tax. This means it reduces the taxable income of the company.
The cost of debt is the effective interest rate a company pays on its borrowings. In India, interest paid on loans is an expense before tax. This means it reduces the taxable income of the company. If the interest rate is 10% and the tax rate is 30%, the actual cost to the company is only 7%. This is because the company saves 3% in taxes. Equity does not enjoy this benefit, making debt a more attractive option for many businesses.
WACC is the average cost of all sources of capital, including equity and debt. Each source is weighted according to its proportion in the total capital.
WACC is the average cost of all sources of capital, including equity and debt. Each source is weighted according to its proportion in the total capital. For example, if a firm has 60% equity at a 15% cost and 40% debt at a 10% cost, the WACC will be a blend of these two. It serves as the 'Hurdle Rate.' A company should only invest in projects that offer a return higher than its WACC.
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