Question

What is capital structure and how important it is?

write 8 sentences explaining it with detail thanks.

Answer 1

Capital structure includes all the sources of funding the project and operations of the project. The funding can be done through debt, equity, preferred stock and working capital. However cost of raising equity is highest among all sources of capital because it is not tax deductible and issuance cost is highest.
Importance of capital structure:
The company can choose an aggressive strategy by increasing leverage ratio or follow a passive strategy of using lower leverage ratio. Leverage means debt to equity ratio. Companies try to use optimal capital structure. This can be done by using optimum amount of debt, equity and preferred stock for funding of project so as to minimise the cost of capital. Choosing a particular capital structure can help in getting higher NPV for a project. Capital structure helps in identifying WACC which is the discounting factor used in evaluating project.
WACC = Weight of Equity * Cost of Equity + Weight of Debt * (1-Tax rate) * Cost of Debt+Weight of Preferred Stock * Cost of Preferred Stock.