Financial Structure That Is Best
While every corporation or firm, private or public, is allowed to employ any structure, any or random combination of debt and equity for a going concern company is neither preferable nor good. The type of structure a company uses has an impact on its WACC (Weighted Average Cost of Capital), which has a direct impact on the company’s valuation. As a result, an ideal structure is required to optimise a company’s worth. WACC is the weighted average of each type of financing’s marginal cost of capital.
The WACC formula is as follows:
WACC = KeWe + Kd(1-tax rate)Wd WACC = KeWe + Kd(1-tax rate)Wd WACC = Ke*We +
Ke stands for “cost of equity.”
We = The financial structure’s weight/proportion of equity.
Cost of debt (Kd)
Wd = Debt’s weight or proportion in the financial framework
For example, ABC Ltd. has a total capital structure of $1 million, with $500,000 in equity and $500,000 in debt. Both stock and debt have a price tag. The cost of debt is the interest paid, whereas the cost of equity is the expected minimum return on an investment. Assuming that the cost of equity is 12%, the cost of debt is 8%, and the tax rate is 30%, the WACC of ABC Limited is
WACC =.12(500,000/1,000,000)+.08(1-0.3)(500,000/1,000,000) WACC =.12(500,000/1,000,000) WACC =.12(500,000/1,000,000) WACC =.12(500,000/1,000,000) W
=.088 (eighty-eight percent)
Some may claim that there is no reason to use debt or pay interest on it. There are a variety of reasons for this, including the fact that a company may not have enough equity to fund its operations and must rely on debt to do so. Another rationale is that debt has a lower effective cost of capital than equity, lowering WACC while increasing value and amplifying certain profitability ratios such as return on equity. The following example demonstrates how the cost of debt is lower than the cost of equity. –
If a corporation requires $100,000 in capital for its operations, it can either issue $100,000 in debt at a 10% interest rate or dilute its stock by 10%. As shown and computed below, the corporation that chooses debt financing pays 10% interest on a $100,000 loan and makes a profit of $273,000. Whereas a company that uses equity financing will make a profit of $280,000 due to no interest costs, the net profit attributable to the owner will only be $252000 ($280,000-10 percent *280,000) because the owner owns only 90% of the company and the remaining 10% is owned by someone else due to the sale of 10% equity.
As a result, debt financing generates a higher profit than equity financing due to the lower cost of debt and the fact that it is tax deductible.
Again, keep in mind the inherent financial risk that debt entails; there are no free lunches, thus the risk associated with debt is also larger. When the value-enhancing benefit of increased debt is compensated by its value-reducing effect, the optimal level of leverage is reached.
Financial Structure Influencing Factors
- Cost of Capital – As previously stated, debt and preference shares are less expensive sources of capital than stock, and a company’s goal is to lower its cost of capital.
- Control – Equity has its limitations as a source of finance. Excessive dilution or selling of a company’s interest can result in a loss of decision-making authority and control.
- Debt has both beneficial and negative aspects. On the one hand, it helps to maintain a low cost of capital because it is a less expensive source of capital than stock, and a modest increase in profit magnifies certain return ratios; on the other hand, it may cause solvency concerns and increase the company’s financial risk.
- Flexibility – The financial structure should be set up in such a way that it can be changed as the environment changes. A company’s ability to survive may be harmed by excessive rigidity.
- Due to insignificant cash flows, a lack of assets, and a missing guarantor for the security of a loan, small-sized enterprises, new companies, or companies with a terrible credit history may not have unlimited access to the debt. As a result, it may be forced to dilute its equity in order to raise funds.
Capital Structure vs. Financial Structure
Some people mix up capital structure with financial structure. There is a tiny distinction between them, despite their many similarities. The phrase “financial structure” encompasses more than just capital structure.
The financial structure encompasses both long and short-term funding sources, as well as the entire liabilities and equity side of the balance sheet. The capital structure, on the other hand, only covers long-term sources of funds such as equity, bonds, debentures, and other long-term borrowings, not accounts payable or short-term borrowings. So, in a nutshell, capital structure is a part of the financial system.