Question

What considerations should the capital structure decision be based on? Provide an example of how you would structure a capital investment and why you choose that finance structure.

Answer 1

A capital structure decision is based on various kinds of factors like cost of capital, tax rate applicable, risk involved etc. However, the main consideration involved in the cost of capital involved. While funding a project or investment, a specific return is expected from the project or investment. If the cost of capital that company will invest in the project is less than the required return then only a project or investment becomes desirable. Therefore, of the cost of capital is high for a particular source of capital and cost of capital is low for a particular source, then the one with lower cost will be selected and more weightage will be given to that source. Yet another consideration is tax system. A classical tax system allows deduction of interest payments and hence effective cost of debt is lower than equity usually. High tax rate would demand high use of debt to get benefit of interest deduction.

In my capital investment decision, I would choose a capital structure with 50% of debt and 50% of equity for the purpose of making a capital investment. The debt part in the structure will allow the company to raise debt at a low effective cost than equity due to benefit of interest deduction. However, use of excess debt can seriously hamper a company's ability to raise further debt and it will also devalue company's value in market. Thus, a optimal structure would be using both debt and equity as sources for funding a capital investment in an effective way.