Capital Structure and the Cost of Capital Funds

Introduction
Capital structure refers to the long term financing sources of a firm. It is composed of long term debt and owners equity. All funds, whether contributed by owners or obtained from debt attract cost. Capital structure depends on a number of factors including cost. In determining the proper capital structure, consideration is given to the amount of return to be gained from use of the funds. A good investor expects returns which are higher than the cost of the investment. While long term finances enable firms to acquire assets for long term operations, day to day operations require a good working capital. Working capital is the short term finances which make it possible for a firm to pay its creditors, interest on debt and other immediate needs. A combination of long term finances with short term finances makes a financial structure of a firm. In this paper, I will discuss the concepts of capital structure, cost of capital, explain the key determinants of financial structure and show why management of this structure is important.

Background of the project

Survival of business in the long run relies on the optimal capital structure. Since investment decisions are made now but the returns are in the future, it is important that such decisions must be based on careful analysis. In most cases, investors have no financial skills to make right determination. Financial managers are entrusted with the responsibility of managing the finances of a firm and advising management of the best options. This paper has been written to fulfill the requirements of Corporate Finance module of an executive MBA program with ESAMI.

Capital Structure
defines Capital structure as..

Cost of Capital
Funds from owners attract costs in terms of dividends and long term debt attracts interest. For large organizations, long term debt financing may come from different sources with different interest rates. Firms need to determine to what extent they can borrow and determine the optimal mix of debt and equity. The most common approach for determining cost of capital involves calculating a weighted average cost of capital (WACC). Firms may continue to borrow up to the lowest point of WACC. Below is an illustration of how an optimal mix of debt and equity can be determined. Cost of Funds Ke

WACC Kd

Optimal mix of Debt and Equity

Proportion % of Debt

Financial Structure

Key Determinants of Financial Structure

Size of the firm Access to financial institutions Management style Nature of the firm

Importance of Financial Structure