Question

How does the capacity a company maintain impact the cost of capital.

Answer 1

Cost of capital is minimum rate of return that a business must earn before generating value.Cost of capital is an important factor in determining the company's capital structure.The optimum capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital.

The cost of debt is less expensive than equity becuase it is less risky.The required return needed to compensate debt investors is less than the required return needed to compensate equity investors,because interest payments have priority over dividends and debt holders received priority in the event of liquidation.However there is to the amount of debt a company should have because an excessive amount of debt increases interest payments,the volatilty of earnings and the risk of bankruptcy.

Companies with consistent cash flows can tolerate a much larger debt load and will have a much higher percentage of debt in their optimal capital structure and vice versa.