The financial structure and the cost of capital

Question 1

What is the capital structure of a firm?

Answer 1

It represents a mix of different securities of a business.

It reffers to the company’s debt to equity ratio showing how risky the activity of a business is

Question 2

What is the cost of equity?

Answer 2

It is the return that stockholders require a company

It is the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

Question 3

What is the cost of debt?

Answer 3

The cost of debt is the effective rate that a company pays on its current debt.

Question 4

What is the target capital structure?

Answer 4

It reffers to the optimal mix of equity and debt that a company uses to finance its activity

Question 5

How does debt financing affect the riskiness of a firm?

Answer 5

Using more debt raises the riskiness of the firm’s earning stream.

A higher proportion of debt leads to a higher expected rate of return

A higher risk associated with greater debt tends to lower the stock’s price

Question 6

What are the factors that influence a corpotation’s capital structure decisions?

Answer 6

1. The firm’s business risk: the greater the risk, the lower the amount of debt that is optimal
2. The firm’s tax position: if tax rate is high use more debt because of tax deductability
3. Financial flexibility: the lower a company’s debt level is, the more financial flexibility it has
4. Manager’s attitude towards risk
5. The growth rate of the firm: firms that are in the growth stage typically borrow money faster
6. Market conditions