Question

What exactly is the capital structure of an organization? Additionally, what do we mean by the cost of capital? When considering capital projects, are there ways of measuring risks and costs associated?

Answer 1

Capital structure of a firm refers to the amount of outstanding debt and equity. It is considered as a liability of the organization. Capital structure usually includes long term debt, subordinated debt and equity of the company. The ultimate aim of any management of the organization is to find out the optimal capital structure where the cost of capital will be minimum. Cost of capital is the average cost that the firm will have to incur in order to raise the required capital. For equity the cost will be the dividend that needs to be paid to shareholders, for debt, it will be the fixed interest that needs to be paid to the lender. While considering capital projects there are various risks which are associated with capital projects, these includes operational risk, market risk etc. Capital budgeting is the process which can be used for the purpose of analyzing the risk associated with capital project. It can also help in determining the cost - benefit analysis of the capital project. Through this technique one can find out the cost and risk associated with the projects and whether the project is feasible for the purpose of investing or not.