Capital structure refers to the mix of short-term and long-term debt owned by the company, along with the levels of common and preferred stock.
The capital structure and the cost of capital are directly related to the financial well-being of a company. When in balance, 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, such as making the best use of resources that are not needed in a future. day. day-to-day operation of the business and even how to purchase equipment that will provide maximum benefits 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 failure of the operation increases.
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 owned by the company, along with the levels of common and preferred stock. The debt will include outstanding bond issues, as well as items payable with a duration of one year or more. Stock will include the retained earnings of the business as well as common and preferred stock held as part of the assets of the business. 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 factory.
This means that the connection between capital structure and cost of capital helps demonstrate how decisions about how to run a business have a direct impact on the debt and equity the business has at any given time. For example, if a cost of capital analysis indicates that the returns from building a new plant will not result in an appreciable increase in revenue generation, the capital structure would be negatively affected by increased debt without some type of growth in capital. offset this additional expense. As a result, the financial stability of the company is negatively affected.
By failing to recognize the relationship between capital structure and cost of capital, you increase the potential to take on additional debt without generating much profit. Over time, this can weaken the business to the point where continued operations are impossible. 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 long-term.