The firm’s capital structure refers to the mix of equity and debt the firm employed. There are actually 3 types of capital, namely debt, equity and preferred equity. Actually these three types of capital differs in only one area, the level of risk. Equity is the riskiest, preferred equity is middle and debt financing has the least risk.
That is why equity investor demand higher return for their investment. Although preferred equity investor and bond investor demand a fixed cost for their capital , they are compensated first if the firm goes bankrupt, reducing their level of risk. Equity investor are the last to get anything.
The good thing about debt financing is that it measures risk and return at a specific point in time. Imagine that a firm can get a low interest rate on debt when the firm is doing good and is making a lot of profit. Assume that this debt will last for 30 years. During that time, business deteriorates and the actual risk and return for investing in that company’s debt has risen. However, the company still enjoys the same old low cost debt. Therefore it is wise to borrow when business is good and strong.
Equity financing is not as rigid as debt financing. Companies have to pay more dividend (cost of equity) during good times and vice versa during bad times. In fact, certain companies do not even pay dividend when the company is making a loss hence zero cost of equity. However, dividend take up a big portion of the profit earned during good times to compensate for the risk taken.
Cost of capital differs across firms and across industries. Certain firms and industries can get a lower cost of capital depending on their level of risk. The risk involved is the default risk or risk of delayed payment. When an investment packs a lot of risk, investor generally wants a higher return. This is because out of the investor’s many investment, he needs the successful investment to pay for the failed investment.
Second Post. Bye
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