What makes up a company's capital structure? Explain the purpose of determining the weighted average cost of capital for a company.
A company's capital structure refers to the combination of its different sources of funding, including debt and equity. It reflects how a company finances its operations, investments, and growth. The main components of a company's capital structure typically include:
1. Debt: This represents the money borrowed by the company, which it must repay over a defined period with interest. Sources of debt financing can include bank loans, bonds, and other forms of borrowing.
2. Equity: This refers to the ownership or shares of the company held by shareholders. Equity financing is obtained by selling shares of the company's stock to investors, who become partial owners and may have voting rights.
The purpose of determining the weighted average cost of capital (WACC) for a company is to evaluate the cost of financing its operations and investments. WACC is the average rate of return a company must generate to satisfy its various sources of financing, taking into account their relative proportions.
The main reasons for calculating WACC are:
1. Capital budgeting decisions: WACC plays a crucial role in determining whether a company should undertake a particular investment or project. By comparing the return required by its investors (WACC) with the projected returns of the investment, a company can evaluate the viability of the project.
2. Valuing the company: WACC is used in determining the present value of a company's expected future cash flows. By discounting the future cash flows using the WACC, analysts can estimate the intrinsic value of the company or specific projects and make investment recommendations.
3. Setting hurdle rates: WACC acts as a benchmark or minimum rate of return that a company must achieve to satisfy its investors. It helps establish return thresholds for new investments and provides a yardstick for evaluating performance.
4. Cost of raising capital: WACC takes into account the cost of various sources of financing, including both equity and debt, and their relative weights. By considering the cost of capital, a company can assess the affordability and attractiveness of different financing options.
Overall, determining the weighted average cost of capital allows companies to assess the cost-effectiveness of their financing choices, evaluate investment opportunities, and make informed decisions to maximize shareholder value.