Capital structure is known as the resource of the organization which includes like combination of value, economical debt, or multiple investments. A firm’ capital framework is the made from the ‘structure’ of its liability. As for example: a company that provides $ 30 billion dollars in value and $ 60 billion dollars in economical debts are said to be 30% equity-financed and 60% debt-financed. The company’s amount of economical debt to total funding would be known as 60% in this example, is determined as the company’s control. For the main town industry framework the concept has been suggested by the famous college students Modigliani-Miller.
Gearing Ratio is the proportion of the main town employed of the company which come from outside of the business fund, e.g. by taking a temporary personal loan etc.
Cost of capital consists of two main component debts and the equities. Composition of debt and equity in the total capital determines the total cost of capital. Total percentage of debt multiplied by the total cost of debt is added to the total percentage of equity multiplied by the total cost of equity is equal to the total cost of capital.
WACC for the given example is calculated as-
Cost of capital= x Cost of Debt (1-tax) + x Cost of equity.
In the given problem data are provided as follows-
Tax Rate 35%
Cost of Debt 8%
Beta of the stock 1.5
Risk free Rate =2%
Return on Market= 11%
First of all we would computer return on equity which is given by
Risk Free rate (RF) + [Return on Market (RM)-Risk free Rate (RF) x Beta]
2+ (11-2) x 1.5 = 12.5%
Therefore cost of capital would be equal to=
0.4x 8 %( 1-0.35) + 0.6 x 12.5%
Capital Structure feasibility
Capital industry is considered if there is no deal or bankruptcy expenses but with perfect details. The firms or personal can economical debt the money at the same interest amount without any issue. Burns say that the best ‘proposition’ was that the value of a organization is separate of its capital framework. Their second ‘proposition’ says that the price of value of the company is equal to the price of value for an unleveraged company, plus an included top quality for economical danger. As the make use of the company improves the problem of the growth of the organization or personal risks are moved between different trader classes so that danger is covered and no included value is created.
The financing decision at the microeconomic level is significantly influenced by how are functioning the economic mechanisms at regional, national and even global level. The decision of selection the sources of funding should consider the influence of some factors, although they are difficult to measure, to quantify. These factors are: the structure of assets, the rate of growth of the business, the sales stability, the rate of return, taxes, tax savings which are not generated by debt, the operating lever, the solvency, prevailing market conditions, internal conditions of the company, financial flexibility, the competence and attitude of the management team, the attitude of investors, creditors and staff investments, the control. However, in the opinion of several financiers, the main criteria for choosing the sources of funding of the company would be: the cost of financing, the financial return, actual payments and the surplus of the cash flow. The cost of capital is seen as the payment to be made by the company for the capital (debt, preferred shares, common shares and retained profits) which is used to finance new investments.
Determining the cost of capital is a particularly important issue in the business world for the following reasons:
Therefore it is recommended to use WACC while calculating the cost of capital as its uses the capital structure of the firm, which gives the clearer picture to the investors or the management for the evaluation of any project.
- To maximize the market value of the company. For this purpose the managers must act to minimize costs, including the cost of capital;
- To take the right investment decisions, requiring the knowledge of managers about the cost of different sources of financing the business;
- To decide in appropriate and optimal terms about the financing policy and the revolving fund policy.
Marginal Cost of Capital
Marginal cost of capital is defined as the cost for the firm incurred by raising the additional unit of capital from the market. Marginal cost of capital increases as more capital is raised from the market.