# Capital structure and cost of capital

## What Is Capital Structure?

Capital structure is the mix or combination of various sources of funds that are used by a company to finance its operations and growth. There are two main sources of finance that are used by a company:- (1) Debt, which consists of long-term debt and short-term debt. (2) Equity, which consists of common shares and preference shares.
A company should have an optimal capital structure. Optimal capital structure has the optimal or ideal balance between the debt and equity in the capital structure. An optimal capital structure minimizes the weighted average cost of capital and maximizes the value of the firm.

## What Is Cost Of Capital?

The company raises funds from various sources to finance its operations and growth. Each of these sources have a cost associated with them. So cost of capital is the cost of raising the funds from various sources. Cost of capital can also be defined as the minimum rate of return which the investors expect for providing  capital to the company. Cost of capital plays a very important role in deciding the capital structure of a company and also in the capital budgeting decisions.
Cost of capital is comprised of :-
(1) Cost of debt.
(2) Cost of preferred equity i.e. preference shares.
(3) Cost of common equity i.e. equity shares.

### (1) Cost Of Debt:-

Cost of debt is the rate of interest that the company pays on its borrowings such as debentures, bonds, term loans from banks and financial institutions and short-term debt. Interest on debt is a tax-deductible expense so generally after- tax cost of debt is considered. The rate of interest can be calculated from the interest expenses of the company as a percentage of the outstanding debt. For e.g. if the interest expenses of the company for the year 2015 are Rs 246.40 crores and the outstanding debt of the company for the year 2014 is Rs 1540 crores. So the cost of debt of the company would be 16% (246.40 × 100 ÷ 1540). This is the before-tax cost of debt. Now we need to calculate the after-tax cost of debt. Let us assume that the tax rate is 20%. So the after tax-cost of debt of the company would be 12.8% {16 × (1 – 0.20)}.

### (2) Cost Of Preferred Equity:-

Preference shares carry a fixed rate of dividend and the dividend is not tax-deductible. Preference shares have the properties of both debt instruments and equity shares. The cost of preferred equity is the rate of dividend fixed by the company on its preference shares. The rate of preference dividend can be calculated as under:-
Preference dividend ÷ net proceeds from issue of preference shares × 100
For e.g. if a company received Rs 1240 crores from the issue of preference shares and paid Rs 173.60 crore annually as dividend on those shares. So the cost of preferred equity would be 14% (173.60 ÷ 1240 × 100).

### (3) Cost Of Common Equity:-

Unlike the debt and preferred shares, common shares do not have a fixed cost associated with them. Cost of common equity is the return that the common shareholders expect from their investment in common shares and if the company does not deliver the expected return, the common shareholders would sell their shares and the price of shares would fall. The most commonly used method for calculating the cost of common equity is Capital Asset Pricing Model (CAPM). The formula for calculating cost of common equity under Capital Asset Pricing Model is:-
Risk-free rate + (beta × risk premium)
Risk-free rate:- Risk-free rate is the risk-free interest rate that is obtained by investing in risk-free securities like government bonds.
Beta:- Beta measures how much the price of a company’s stock moves against the market as a whole. The market has a beta of 1. The price of the company’s stock that moves more than the market has a beta above 1 and the price of the company’s stock that moves less than the market has a beta below 1.
Risk premium:- It is the equity market risk premium which the common shareholders expect over and above the risk-free rate to compensate them for taking extra risk by investing in common shares.
For e.g. the risk-free interest rate for a 10-year-old government bond is 8%. The beta of company’s common stock is 1.3 and the risk premium expected by the common shareholders is 6%. So the cost of common equity would be 15.8%
{8 + (1.3 × 6)}.

### Weighted Average Cost Of Capital:-

Weighted Average Cost of Capital (WACC) is the combined average cost of all the sources of capital i.e. debt, preferred equity and common equity used by a company. So all the sources of capital are taken into consideration to calculate the Weighted Average Cost of Capital. WACC can also be defined as the average rate of return which all the investors expect for providing capital to the company. For calculating WACC, cost of each source of capital is weighted in proportion to the share each source of capital has in the company’s capital structure.

#### Example Of Weighted Average Cost Of Capital:-

For calculating Weighted Average Cost of Capital following things are needed:-
– Market value of debt and cost of debt.
– Market value of preferred equity and cost of preferred equity.
– Market value of common equity and cost of common equity.

Market value of debt is not easily available. So we have to take the value of debt which is in the company’s balance sheet. Earlier we had taken the value of debt as Rs 1540 crores and calculated the after-tax cost of debt as 12.8%. We will use the same figures in the calculation of WACC.

Market value of preferred equity is also not available easily. So we have to take the value of preference share capital in the company’s balance sheet. Earlier we had taken the value of preference share capital as Rs 1240 crores and calculated the cost of preferred equity as 14%. We will use the same figures in the calculation of WACC.

Let us assume that the total market value of common equity is Rs 16800 crores. We had earlier calculated the cost of common equity as 15.8%. So we will take the same in the calculation of WACC.

So now we have all the required information to calculate WACC. We can find out the WACC by using the below method:-

Market value of debt ÷ (market value of debt + market value of preferred equity + market value of common equity) × cost of debt

1540 ÷ (1540 + 1240 + 16800) × 12.80 = 1.00

Market value of preferred equity ÷ (market value of debt + market value of preferred equity + market value of common equity) × cost of preferred equity

1240 ÷ (1540 + 1240 + 16800) × 14 = 0.89

Market value of common equity ÷ (market value of debt + market value of preferred equity + market value of common equity) × cost of common equity

16800 ÷ (1540 + 1240 + 16800) × 15.80 = 13.56

1.00 + 0.89 + 13.56 = 15.45

So the weighted Average Cost of Capital of the company is 15.45%.