Question

Please discuss how capital structure affect a firm's cost of capital.

Answer 1

A firm's cost of capital depends on the debt to equity ratio of the firm. Debt is tax-deductible whereas equity does not have any tax benefits.

Cost of capital = Weight of debt*Cost of debt*(1-Tax rate) + Weight of equity*Cost of equity

Optimum leverage or debt in the capital structure ensures that the cost of capital is minimized. If the debt is increased too much in the capital structure, then equity becomes too expensive in the sense that equity shareholders demand a much higher rate of return due to the increased risk of higher leverage. Also, if equity if much higher than an optimal point in the capital structure, then the company is not able to take advantage of the tax benefits associated with the debt.