• Capital Structure deals with the issue of right mix of Debt and

Equity in the long term capital of firm.

• Optimal Capital Structure Maximises the value of the firm and

minimises the cost of capital. Capital Structure Decisions can
affect the value of the firm either by changing the expected
earnings of the firm or its cost of capita or both.

• Thus, there exists a relationship between cost of capital, capital

structure and value of the firm. However, there are differences in
opinion regarding this relationship which lead to different
theories of capital structure.

• Therefore, company should select its appropriate capital structure

with due considerations of all factors. 2
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What is weighted average cost of capital (WACC)?
 Companies often run their business using the capital they raise
through various sources. They include raising money through
listing their shares on the stock exchange (equity), or by issuing
interest-paying bonds or taking commercial loans (debt). All such
capital comes at a cost, and the cost associated with each
type varies for each source.

 WACC is the average after-tax cost of a company’s various capital

sources, including common stock, preferred stock, bonds, and any
other long-term debt. In other words, WACC is the average rate a
company expects to pay to finance its assets.

 Since a company’s financing is largely classified into two types –

debt and equity –WACC is the average cost of raising that money,
which is calculated in proportion to each of the sources.

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 WACC Formula
WACC=WdRd(1-T)+WeRe

Wd=Weight of debt
Rd=Cost of debt
T= Tax rate
We=Weight of equity
Re=Return of Equity

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Hamada Equation
 is a method of analyzing a firm's cost of capital as it uses
additional financial leverage. Draws upon the Modigliani-Miller
theorem on capital structure. The higher the Hamada equation beta
coefficient, the higher the risk associated with the

rs = rRF + (RPM)bi CAPM version of of the cost of equity

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Bigbee’s beta at different debt/ equity ratios are shown in column 5
of Table 14-3. The current cost of equity is 12 percent as shown at
the top of Column 6:

rs = rRF + Risk Premium

= 6% + (4%) (1.5)
= 6% + 6%
= 12%

If Bigbee changes its capital structure by adding debt, this would

increase the risk stockholders would have to bear. That, in turn,
would result in a higher risk premium. Conceptually, this situation
would exist:

rs = rRF + Premium for business risk + Premium for Financial Risk

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