Learning Objective

Important Terms

The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds. The cost of equity is the return that ordinary stockholders expect to receive from their investment. The cost of loan stock is the rate, which the company must provide its lenders. The weighted average cost of capital (WACC) firm’s capital structure is the average of the cost of its equity, preferred stocks and loan stocks.
An ideal mix of debt, preference stocks and common equity can maximizes the share prices. Debt capital is regarded, as cheap source of finance to the business but will also increase the finance risk of the company. Common stocks regarded as less risky but might lead to loss of voting rights if bought by outsiders.

Factors Influencing Capital Structure

Business risk
Risk associated with the nature of the industry the business operates and if the business risk is higher the optimal capital structure is required.

Tax position
Debt capital is regarded as cheaper because interest payable is deductible for tax purposes. Advantage not much for businesses with unrelieved tax losses, depreciation tax shield as they already have an existing lower tax burden.

Financial flexibility
Depends on how easy a business can arrange finance on reasonable terms under adverse conditions. Flexibility in raising finance will be influenced by the economic environment (availability of savers and interest rates) and the financial position of the business.

Managerial style
How much to borrow also depend on managers approach to finance risk. Conservative managers will usual try to keep the debt equity ratio low.

Business and Finance Risk

Business risk
The variability in operating income caused but inherent factors of the business other than debt financing. Can be influenced by changes in prices, variability of inputs, sales volume, and competition levels.

Finance risk
Additional variability in return that arises because the financial structure contains debt. Finance risk measured through gearing/leverages ratios.

Financial gearing
Extent to which debt finances firms total capital structure
Debt equity ratio: Total debt
Total assets

Times interest earned
Measures the firm’s ability to meet its annual finance interest payments.

TIE ratio = Earnings before interest and tax
Interest charges

Operational gearing
Measures to what extent are fixed costs used in firms operations. Breakeven point analysis will measure the relationship between sales volume, variable cost and the fixed costs. Breakeven point is the level of sales where the firm is neither making profits nor losses i.e. Sales value equals costs.