Different companies choose different financial structures (debt vs. equity). Is there a preferred model? What are the positives/negatives of a higher % of each?
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Capital structure means mix composition of debt and equity in the organization. It affects the cost of capital of the organization. A firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.
The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors.
Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).
Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. In case of preference shares, the dividend rate can be taken as the cost since it is the amount, which the company intends paying against preference shares. As is the case of debt the issue expenses or discount/premium on issue has also to be taken into account.
Alternative capital structure:
This structure will be costly as the cost of debt is cheaper than cost of equity
1) Permanent Capital: It need not be paid back
2) Borrowing Base: It can be used to trade on equity
3) Dividend Payment Discretion: The payment of dividend is in the hands of management
4) No Mortgage
Unlike debt this does n't involve the mortgage. Thus assets are free of any encumbrance.
5) Wealth creation tool
This can be used to create wealth for employees and ...
1260 words explain the benefits of different financial structures in various percentages.