Why do firms have different capital structures and how does capital structure influence a firm’s weighted average cost of capital?
Capital structure tells more about a firm finance, growth, and its operations using different sources of funds. There are several different types of sources of resources, and they include short-term debt, preferred equity, common equity, and long-term debt. Factors that result in organizations having different capital structure include firstly, business risk, having a higher different risk means having optimal debt ratio. Secondly, company’s tax exposure, an organization that uses debt finances means it will have tax-deductible meaning the financing is cheaper. Financial flexibility, the different firm uses different sources of funds as they seem comfortable to raise capital during financial difficulties. Fourthly, the management style, more conservative managers will favor fewer debt finances to increase profits will aggressive managers will use debt finances to enable the firm to grow quickly. Other factors include growth rate and market conditions.
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What are the essential sources of financing included in a firm’s capital structure? Specifically, what financing sources are excluded from the firm’s capital structure when calculating firm WACC?
The basic fonts of funding that is comprised in a firm’s capital structure include the capital markets which included new rights issues and share issues, loan stock, and retained earnings. Other important sources of financing are bank borrowing, government sources, venture capital, franchising, and business expansion scheme funds. The funding sources omitted from the company’s capital structure include when calculating WACC are accounts payable and accrued expenses.
(Weighted average cost of capital) The target capital structure for JT Industries is 40 percent common stock, 10 percent preferred stock, and 50 percent debt. If the cost of common equity for the firm is 18 percent, the cost of preferred stock is 10 percent, the before-tax cost of debt is 8 percent, and the firm’s tax rate is 35 percent, what is JT’s weighted average cost of capital?
WACC = (Weight of Common Stock* Cost of Common Stock) + (Weight of Preferred Stock* Cost of Preferred Stock) + (Weight of Debt* After Tax cost of Debt)
= 0.4 * 0.13 + 0.1 * 0.1 + 0.5 * 0.08 (1- 0.35)
= 0.052 + 0.01 + 0.026
=0.0088
WACC = 8.8%
