The capital structure and cost of capital have a direct relationship, affecting a company’s financial well-being and investment decisions. Capital structure refers to debt and equity, while cost of capital is the expected returns from a project. Failing to balance them can negatively impact a business’s stability and viability.
The capital structure and the cost of capital have a direct relationship in terms of the financial well-being of a company. When balanced, both the capital structure and the specific type of cost of capital employed can help select the right type of investments to make on behalf of the company, how to make the best use of resources that are not needed for the day to day operation of the business, and even how to purchase equipment that provides the greatest benefit over time for that core operation. Without relating the capital structure and cost of capital to business activities in the most productive way, the potential for operation failure is increased.
To understand the relationship between capital structure and cost of capital, it is necessary to define each term. Capital structure refers to the mix of short-term and long-term debt held by the business, along with the levels of common and preferred capital. Debt will include any outstanding bond issuance as well as payables with a duration of one year or more. The shares will include retained earnings from the business, as well as common and preferred shares of stock held as part of the company’s assets. The cost of capital refers to the benefits or returns that a company expects to generate by taking on a specific project, such as building a new manufacturing plant.
This means that the connection between capital structure and cost of capital helps demonstrate how decisions about how to operate a business have a direct impact on both the debt and equity that the business owns at any given time. For example, if a cost of capital analysis indicates that the returns from the construction of a new plant will not result in an appreciable increase in revenue generation, the capital structure would be negatively affected by the increase in debt without some type of capital growth to offset that extra expense. As a result, the financial stability of the business is negatively affected.
Failing to recognize the relationship between the capital structure and the cost of capital increases the potential to borrow more without generating much benefit. Over time, this can weaken the business to the point that continued operations are not possible. Keeping your debt-equity balance within a reasonable range will equip your business to remain viable during economic downturns and have a better chance of staying in business for the long term.
Smart Asset.
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