Capital Structure also known as financial structure the combination of financing either by debt or equity. Both debt and equity financing play critical role in capital investments/business operations.
Capital Structure also known as financial structure the combination of financing either by debt or
equity. Kasozi (2013, p.465), propound the importance of investment decision-making process
in a firm regarding to achieve the success. This decision generally based on strategic,
economic, or behavioral motives. The underlying benchmark to any decision whether defensive
or aggressive actions is to strengthen the firm market position. According to POPESCU, the
financing decision concerns choosing between their “own sources (share capital, depreciation
fund, profits, reserve funds, additional capital, revenues from investments), attracted sources
(domestic resource mobilization) and borrowed sources (credits)”.
Debt Financing
Debt Financing refer to the process of borrowing funds from commercial banks/other lenders
(most common form is loan) to finance the business and repaying with interest(s). It should be
noted that debt financing might cause some restriction on company activities exploring the
outside opportunities of its primary business.
There are advantages in debt financing. For instance, the interest paid is tax deductible and
lenders just care the loan will be repaid. The simplicity in forecasting expenses.
Equity Financing
Equity financing is raising finance for capital investment/business operations by issuing stocks.
Issuance of stocks means funders are going to become shareholders in the business, this
implies that they are equally affected when the business registers either profit or loss. Using
equity option to raise finance dilutes the complete control and ownership of the business. Also,
there is no additional financial burden is imposed on the business due to no force on monthly
payment and no commitment to repay the funds (POPESCU, p.1391-1395).
Moreover, the cost of capital is the total cost of raising capital i.e. cost of equity and cost of debt.
In order to calculate the cost of capital, both the cost of equity and debt will be weighed and
added. This is done using an important tool “the weighted average cost of capital (WACC)”. The
main objective of balancing between debt and equity is to keep WACC is check, this is also
crucial to keep the business prepared in case of any subsequent financing need.
Following are some factors to consider while making financial decisions:
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