Capital Structure and Cost of Capital
(How Much to Borrow vs Own? And What Does Money COST?)
Should a company use 70% debt and 30% equity? Or 40-60? The right mix (capital structure) determines profitability AND survival. This chapter covers leverage, 3 theories of capital structuring, taxation impact, cost of debt/preference/equity, CAPM, WACC, marginal cost, and 7 common misconceptions.
Banky Learns to Design the Perfect Mix! ⚖️💰
A company wants ₹500 lakh capital. Should it borrow ₹300L (debt) + invest ₹200L (equity)? Or more debt for “trading on equity”? Or less debt for safety? The answer depends on cost of capital, tax benefits, and risk appetite.
Capital Structure + Cost of Capital — Complete
📖 Part 1 — Capital Structure & Leverage
Capital Structure = Proportion of DEBT and EQUITY in total long-term funds. Debt = term loans, debentures, FDs. Equity = share capital, reserves, retained profits, preference shares.
Leverage/Gearing: High debt ratio = Highly Leveraged/Geared. Low debt = Low Leveraged. Trading on Equity: Using borrowed funds to earn MORE than the cost of borrowing → extra profit goes to equity holders. Works when ROI > Cost of debt. Dangerous when business declines!
5 Factors influencing capital structure: (1) Banking/industry norms (D/E norms), (2) Degree of control (don’t dilute voting), (3) Trading on Equity (leverage benefit), (4) Cost of Debt (double-edged sword!), (5) Size & business plans of the firm.
3 Theories: (1) Net Income (NI): More debt = lower WACC (because debt is cheaper). No limit on leverage benefit. (2) Net Operating Income (NOI): WACC stays CONSTANT regardless of leverage (market adjusts cost of equity upward). (3) Traditional: WACC decreases initially with debt, stays flat, then INCREASES beyond a point (most realistic!).
CAPM is NOT used for capital structure decisions — it’s used for cost of equity! Exam trap!
💰 Part 2 — Cost of Capital: Debt, Preference, Equity
Cost of Debt: For term loans = stated interest rate. For bonds/debentures in secondary market = YTM. Interest on debt = TAX DEDUCTIBLE (tax shield!). After-tax cost of debt = Rate × (1 − Tax rate). ALL forms of interest provide tax shield — bonds, FDs, inter-corporate deposits!
Cost of Preference: Same formula as YTM. But preference dividend is NOT tax-deductible (no tax shield like debt).
Cost of Equity (4 methods):
Risk-free rate + Beta × Market premium. Beta = sensitivity of stock vs market. Higher beta = more volatile = higher required return.
Bond Yield + Risk Premium: Cost = Yield on firm’s LT bonds + Equity risk premium.
Dividend Growth Model: Cost = (Dividend/Price) + Growth rate.
Earnings-Price Ratio: Cost = Expected EPS / Market Price.
Key insight: Cost of equity > Cost of preference > Cost of debt. Because equity holders take MAXIMUM risk!
Example: Equity 40% at 20%, Pref 10% at 15%, Debt 50% at 10% → WACC = 8 + 1.5 + 5 = 14.5%
Marginal Cost of Capital: Cost INCREASES as more capital is raised. Breaking point = level beyond which cost rises. Optimal Capital Budget: Where IRR of next project = Weighted Marginal Cost.
Floatation Cost: Issue expenses for raising capital. Revised WACC = WACC / (1 − floatation cost).
⚠️ Part 3 — 7 Misconceptions About Cost of Capital
1. “Equity capital has NO cost” — WRONG! Equity holders expect return (opportunity cost). 2. “Retained earnings are FREE” — WRONG! They have opportunity cost too. 3. “Depreciation fund is cost-free” — WRONG! Opportunity cost applies. 4. “Include current liabilities in WACC” — WRONG! Only long-term capital. 5. “Use historical cost of debt” — WRONG! Use current market cost (YTM). 6. “Dividend % = cost of equity” — WRONG! Use CAPM or growth model. 7. “Use existing WACC for new project” — WRONG! Each project has its own risk profile.
Net Income approach is NOT used for cost of equity — it’s a capital structure theory! (CAPM, Bond Yield, Dividend Growth, E/P ratio = cost of equity methods)
Exam-Ready Points
🎯 Must Remember!
- Capital Structure = Debt vs Equity proportion. High leverage = high debt = high risk + potential reward.
- 3 Theories: NI (more debt = lower WACC), NOI (WACC constant), Traditional (WACC has sweet spot — most realistic).
- CAPM is NOT a capital structure approach. It’s for cost of equity!
- NI approach is NOT for cost of equity. It’s a capital structure theory!
- Cost hierarchy: Equity > Preference > Debt (because risk hierarchy is opposite).
- Interest on ALL debt = tax deductible (bonds, FDs, inter-corporate deposits — ALL provide tax shield).
- Preference dividend ≠ tax deductible. Only DEBT interest is tax-deductible.
- CAPM: Ra = Rrf + β(Rm − Rrf). Higher beta = higher cost.
- WACC: Sum of (weight × cost) for each component. Used as benchmark for project evaluation.
- Retained earnings have cost! Opportunity cost. NOT free!
- Cost of equity ≠ dividend percentage. Use CAPM, Dividend Growth, Bond Yield + Premium, or E/P.
- Floatation cost: Revised WACC = WACC / (1 − floatation %). Makes WACC higher.
- Capital structure decision affected by: Banking norms, Cost of debt, Taxation, Control, Trading on equity — ALL.
- Normally, cost of equity > cost of debt = CORRECT statement.
📝 Past Exam Questions
Last-Minute Flash Cards
⚡ Module C • Chapter 6 (Unit 24) Done!
- Capital Structure: Debt vs Equity. High leverage = risky but potentially profitable.
- 3 Theories: NI (debt = better), NOI (irrelevant), Traditional (sweet spot — most realistic).
- Tax shield: ALL debt interest is deductible. Equity dividends are NOT. More debt → less tax.
- Cost: Equity > Preference > Debt. CAPM for equity: Ra = Rrf + β(Rm − Rrf).
- WACC: Weighted average of all components. Marginal cost increases with more capital.
- 7 Misconceptions: Equity/retained earnings are NOT free. Don’t use historical cost. Don’t include CL.
Banky says: “Equity cost > Debt cost! CAPM for equity, NOT capital structure! Tax shield on ALL debt! WACC = weighted average! Retained earnings = NOT free!” 🎉⚖️💰
Next: Chapter 25 — Capital Investment Decisions / Term Loans! 💪