If you look at a company’s balance sheet, you will immediately notice that it is laid out according to the accounting equation -- assets equal liabilities plus stockholders' equity. The left side, assets, represents what the company owns. The right side is the firm’s capital structure: it’s how assets are paid for. The different components of the capital structure each contribute to the total capital of the company and each has a specific cost.
The liabilities portion of the balance sheet reveals the short- and long-term debt of the company. The long-term debt is part of the capital structure. It consists of notes, bonds and other obligations that mature in over a year. The cost of each item is the interest it pays. To get the weighted average cost of debt, you multiply the amount of each component by its interest rate and then divide by total debt. Debt must be repaid or else lenders can force the liquidation of the company. Interest on debt is tax-deductible by the company, but dividends on stock are not.
The stockholders’ equity portion contains various forms of stock, plus warrants and retained earnings -- the accumulated profit of the firm. Common stock represents the ownership of the company. It can receive dividends, which can change over time, and confers voting rights on shareholders. Unlike debt, failure to pay a dividend does not force a company into default. If the company is liquidated, common stockholders are the last to receive any proceeds, behind lenders and preferred shareholders.
These shares have a fixed dividend that must be paid before common stock dividends can be distributed. Companies can issue multiple series of preferred shares. The shares do not confer voting rights and are often callable -- the issuing company can force shareholders to sell the shares back to the company for a preset price. Preferred shares may be convertible into common shares. Cumulative preferred shares must eventually pay out any skipped dividends. Preferred shares are subordinate to debt when a company is liquidated.
Weighted Average Cost of Capital -- WACC
A company can finance a new project by using some combination of the capital structure’s debt and equity. WACC is a formula to calculate the cost of new financing. It combines the cost of debt, which is interest, with that of equity shares. The cost of shares is equal to the rate of return investors require to buy those shares. Each component is weighted by its respective market value and then averaged over total market value, giving WACC. The higher a company’s WACC, the higher the rate of return needed on new projects for them to be profitable. Thus, companies with a relatively high WACC must be very discriminating when choosing new projects to fund.
- Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice; H. Kent Baker, Gerald S Martin
- The Capital Structure Decision; Harold Bierman
- Capital and Its Structure; Ludwig M. Lachmann
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