What Is the Relationship between Capital Structure and Cost of Capital?
Capital structure and cost of capital have a direct relationship in terms of the financial well-being of a company. When in balance, both the capital structure and the specific type of cost of capital employed can aid in selecting the right type of investments to make on the behalf of the company, how to make the best use of resources that are not necessary for the day to day operation of the business, and even how to purchase equipment that provides the most benefit over time to that core operation. Without relating the capital structure and cost of capital to business activities in the most productive manner, the potential for failure of the operation is increased.
In order 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 both short- and long-term debt held by the business, along with the levels of common and preferred equity. The debt will include any outstanding bond issues, as well as payable items with a duration of a year or more. Equities will include the retained earnings of the business as well as the common and preferred shares of stock held as part of the company assets. Cost of capital refers to the benefits or returns that a business expects to generate from taking on a specific project, such as building a new manufacturing facility.
This means that the connection between capital structure and cost of capital helps to demonstrate how decisions on how to operate a business have a direct impact on both the debt and the equity that the business holds at any given point in time. For example, if a cost of capital analysis indicates that the returns from building a new plant will not result in any appreciable increase in revenue generation, the capital structure would be adversely affected by the increase in debt without some sort of equity growth to offset that extra expense. As a result, the financial stability of the business is adversely affected.
By failing to recognize the relationship between capital structure and cost of capital, the potential for taking on additional debt without generating much in the way of benefits is increased. Over time, this can weaken the business to the point that continued operations are not possible. Keeping the balance between debt and equity within a reasonable range will equip the business to remain viable during economic downturns and have a better chance of remaining in operation over the long-term.
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