Individual Project: Capital Structure

Capital structure is a strategic combination of debt and equity that a company uses to
finance its overall activities. Representation of the debt is done through bonds or loans while the
expression of equity is in the form of common stock, preferred earnings, and retained
earnings. Some companies also consider short-term debt as a part of the capital structure. Debt
consists of the money that the company borrows, and it is always due to the lender’s interest.
Equity, on the other hand, consists of the ownership rights of all the stakeholders in the
company. The stakeholders do not have to pay back any investment to the company. In the
capital structure, there is a determination of the debt-to-equity ratio. The main focus of the rate is
to determine the level of risk of the company’s borrowing behaviors. A company might have
debt, but its operations are sufficient to make payments to the debt both in the short- and long–
run.
The debt and equity of a company can be found on the balance sheet. The balance sheet
consists of information about the assets of the company. The investments are purchased by the
debt and equity of the company. It is possible to have a company’s capital structure combining
the long-term debt, short-term debt, common stock, and preferred stock. While analyzing a
company’s capital structure, it is vital to consider a section of the short- and long-term debts. A
company that largely depends on its obligations in funding its operations usually has an
aggressive capital structure that risks the investor’s Berry, Betterton, and Karagiannidis, 2014).
However, it is possible to stake the primary source of the company’s growth. Debt is one of the
ways through which a company can be able to raise income in the capital market. A company

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can take advantage of the debt because of the tax benefits and interest payments. The payments
which will be made from the borrowing of funds may encounter tax deductibility.
WACC
Weighted Average Cost of Capital (WACC) is a combination of capital from different
sources. The three primary sources include ordinary shares, preferred shares, and debt. For each
of the money, the weighing is done as a percentage concerning the capital Berry, Betterton, and
Karagiannidis, 2014). All the sources will be summed up to get the overall amount. WACC is a
critical component in financial modeling, as it is possible to use a discount rate to determine the
business’s net present value. The formula for computing the WACC is as follows
WACC = (E/V*Re) + [(D/V * Rd) * (1-T)]
Where:
E – The market value of the firm’s equity, which in most instances, is the market cap rate.
D – The market value for the firm’s debt.
V – The total value of the equity (A combination of equity and capital.)
E/V – The portion of the capital that represents the equity.
D/V – The portion of capital that represents the capital.
Re – The cost of equity. Re can also be the required rate of return.
Rd – The cost of debt. The cost should be the one yielded to maturity based on the available
debt.
T – Rate of tax.
From the scenario, the following information is available and will assist in determining the
WACC.
Weights of 40% debt and 60% common equity (no preferred equity)

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 A 35% tax rate
 The cost of debt is 8%
 The beta of the company is 1.5
 The risk-free rate is 2%
 Return on the market is 11%
Based on the information provided, the following formula will be applicable
WACC = (Weight if common equity * The company’s cost of equity Re) + (Cost of Debt *
Weight of Debt * [1-tax rate])
Re = 2% + 1.5(11% – 2%) = 15.5%
WACC = (60% * 15.5%) + (40% * 8% * [1-35%]) = 11.38%
Feasibility of the Project
The WACC for the company is 11.38%, and it will be possible to reveal the breakeven
point when the amount is less than the WACC. Thus, there is a high chance that the company
will incur losses. The feasibility rate of the project is low and should not be accepted. However,
if the amount is higher than that of WACC, the company will likely experience increased returns
on its investment, and the project should be accepted. Based on the computation, the amount is
higher than the WACC, and the company should consider obtaining the project as it is feasible.
Recommendation for Project Evaluation
The optimal capital structure is the best combination of the debt and equity finances that
will be effective and efficient in capitalizing on the company’s market value. Also, there is a need
to minimize the cost of capital. Debt finances will provide the least cost of capital due to the
deductibility of tax. However, when the debt is high, it increases the shareholders’ financial risk
and the return on equity. Minimizing the weighted average cost of capital is one way of

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optimizing the low-cost mix in financing the debt. In the absence of taxes and bankruptcy, the
firm’s value is unaffected because of the capital structure. When the cost of capital is less, the
company’s present value will be high in the future cash flows and having a discounted WACC.
The cost of debt is less costly than equity since it has less risk. Based on the discussion above, a
computation of the WACC, the company should consider using the weighted average cost of
capital in evaluating the project.
While using WACC, there will be no limitations on the amount of debt that the company
should have for managing the operations. The amount of debt will be key in increasing the
interest payments, the volatility of the earnings, and the risk of going through a bankruptcy. The
increase in the fiscal risk implies a need to have more returns that will be used to compensate the
shareholders. There will be an increase in the WACC and a decrease in the enterprise’s market
value, which makes the evaluation more effective. The strategy will equally use enough equity
that will be essential in mitigating the risk of not being in a position to pay their debt (Berry,
Betterton, and Karagiannidis, 2014). Also, using WACC in the evaluation will take into account
the variation that takes place in cash flow. If there is consistency in the company’s cash flow,
they will be able to accommodate higher debts, and there will be a much higher percentage of
debt in their optimal capital structure. It is possible to compute the percentage using WACC
through evaluation.
Marginal Cost of Capital
As discussed earlier, the company can raise funds through several sources, such as
common stock and preferred shares. Each of the origins of capital has a specific cost to the
organization. The marginal cost of money is the cost encountered to increase the new capital
form from each particular source. The return rate that a stakeholder and the holder of debt

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anticipate before investing in the company. As the company raises the capital, the marginal cost
of capital will rise. Such is because money is a scarce resource for many companies. It is a
different form of the average cost of capital that focuses on the cost of equity and the already
existing debt. It is important to distinguish between the average cost of capital and the marginal
cost of capital.
All the returns that arise from new projects need to be compared with the marginal cost of
capital and not the average capital cost. The new project needs to be embraced only if the
anticipated return is higher than the required return. The increase of marginal cost of capital
taking place in steps and not through linearity. Such is because the company can finance a
certain section of new investment through reinvestment of earnings. Their reinvestment of the
earnings should take place without an increase in the cost of equity. However, when the expected
capital surpasses a combination of the retained earnings and debt, there will be an increase in
capital’s marginal cost. It is possible to create the marginal cost of capital through the breaking
point. The breakpoint refers to the overall amount of new investment that is possible to finance
and new capital that can be increased without before a jump in the marginal cost of capital that is
expected.

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Reference

Berry, S., & Betterton, C., & Karagiannidis, L. (2014). Understanding Weighted Average Cost of
Capital: A Pedogeological Application. Journal of Financial Education, 11-32.