Capital structure refers to how a company finances its assets. The two main sources of capital are debt financing and equity financing. A cost of capital exists because investors want a return equivalent to what they would receive on an investment with an equivalent risk to persuade them to let the company use their funds. The market values of debt and equity are used to calculate the weights of the components of the capital structure.
The yield to maturity (YTM) on a company’s outstanding bonds represents the return that debt holders are requiring to lend money to the company. Because interest expenses are tax-deductible, the cost of debt to the company is less than the YTM. The cost of equity capital is not directly observed, so financial managers must estimate this cost. Two common methods for estimating the cost of equity capital are the constant dividend growth model and the capital asset pricing model (CAPM).
Calculate the weighted average cost of capital (WACC) using the formula
Remember that the WACC is an estimate; different methods of estimating the cost of equity capital can lead to different estimations of WACC.
An unlevered firm uses no debt in its capital structure. A levered firm uses both debt and equity in its capital structure. In perfect financial markets, the value of the firm will be the same regardless of the firm’s decision to use leverage. With the tax deductibility of interest expenses, however, the value of the firm can increase through the use of debt. As the level of debt increases, the value of the interest tax shield increases.
A company wants to choose a capital structure that maximizes its value. Although increasing the level of financial leverage, or debt, in the capital structure increases the value of the interest tax shield, it also increases the probability of financial distress. As the weight of debt in the capital structure increases, the return that providers of both debt and equity capital require to entice them to provide money to the firm increases because their risk increases. Trade-off theory suggests that the value of a company that uses debt equals the value of the unlevered firm plus the value of the interest tax shield minus financial distress costs.
Preferred stock is a type of equity capital; the owners of preferred stock receive preferential treatment over common stockholders in the order of claimants. A fixed dividend is paid to preferred shareholders and must be paid before common shareholders receive dividends. Equity capital can be raised through either retaining earnings or selling new shares of stock. Significant flotation costs are associated with issuing new shares of stock, making it the most expensive source of financing. Convertible debt allows the debt holders to convert their debt into a fixed number of common shares instead of receiving the face value of the stock at maturity.