Question

I. Explain the meaning of capital structure, cost of capital, and weighted average cost of capital (WACC).

II. Describe how capital structure and cost of capital affect the way that a company is valued by investors.

III. Utilize vocabulary and explanations suitable for a non-expert in finance to understand the communication.

Answer 1

Answer(1): Capital structure- It refers to amount of debt and equity in the company. Capital structure means how a company finances its operations? How a company raises funds from the market. Capital structure is the mix of debt and equity in the company.

Debt- It is the obligation that company has to pay after a certain period of time. Company also has to pay interest over debt. It can be raise by issuing bonds or by taking bank loan.

Equity- It represents the ownership and voting right in the company. Company has to pay dividend to shareholders. It can be raised by issuing shares in the primary market through Initial public offerings (IPO).

Cost of Capital- It is the cost that incurs in raising the funds either through debt or through equity. It is the cost that a company has to pay on its capital.

Types of Cost of capital:

Cost of debt- It is the interest that company has to pay on debt.

Formula: Cost of debt(Rd) = Interest * (1=Tax rate)

Cost of equity- This is the minimum expected return that shareholders expect from the company.

Formula: Cost of equity (Re)= Rf + Beta (Rm - Rf)

Where Rf is risk free return, Rm is expected market return.

WACC- Weighted average cost of capital is cost of capital in which each category of capital is given weights on the basis of its percentage in the capital structure.

WACC = (Cost of equity * % of Equity) + (Cost of debt * % of Debt) + (Cost of retained earnings * % of retained earnings)

Answer(2): Investors choose the company that provides higher rate of return on equity and debt holders and other creditors give the loan to company only when it is providing higher rate of interest. People who provides capital assistance to company always demand for higher return.