Question

Explain the relationship between capital structure and cost of capital

Answer 1

CAPITAL STRUCTURE:It is defined as the Distribution of debt and equity in the Company Finances.In simple terms distribution of Debt or Equity for the Company to run its Operations.

COST OF CAPITAL:It is a minimum return required to decide whether to go for an investment or not, Kind of opportunity cost of making an investment.Return that an investor could have earned by investing somewhere else with same risk.

Capital structure and cost of capital are interrelated. As leverage increases, the debt cost and equity cost increases,Lower the position in the capital stack, Higher the expected return.For Example:-The cost of capital will increase in following sequence :debt,mezzanine and equity

Alterations of capital structure can impact the cost of capital,The net income ,The leverage ratios and the liabilities of publicly traded firms, The cost of equity is higher than that of cost of debt. So increasing equity financing usually increases WACC.

Cost of capital is an important factor in determining the Company's Capital structure. Companies are usually looking for the optimal combination of debt and equity to minimize the Cost of capital. Determining a Company's optimal Capital structure can be tricky endeavour because both debt financing and equity financing carry respective advantages and disadvantages.