Capital Structure & the Cost of Capital

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  • 0:03 What Is a Captial Structure?
  • 1:11 Cost of Debt
  • 3:12 Cost of Equity
  • 4:47 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define capital and a firm's capital structure. We'll also discuss the costs associated with each component in the capital structure and learn about the concept of risk and return.

What Is a Capital Structure?

Advertising, expansion, operations, research and development, acquisitions, and mergers require capital. Capital is basically money, while capital structure is the financial resources a company has available to finance these activities. When companies desire to grow and expand, or simply pay operational costs, their capital structure includes three components: cash, debt, and equity. Cash simply represents an asset the company owns; therefore repayment is not required and there aren't any fees or other costs associated with using cash. However, there are costs that come with financing with debt and equity.

As George sits in his office reading and attempting to understand the difference between debt and equity, he receives a phone call from his accountant, Sandra. Sandra has been consulting with George about financing the company's latest venture. He asks Sandra if she could explain the difference between debt and equity and the related costs, since he's confused after reading about capital structure. Sandra and George meet at a local coffee shop. Let's listen to their discussion.

Cost of Debt

Sandra conveys to George that financing with debt includes obtaining a loan from a financial institution or issuing bonds. Since George has financed his business, Blue Ridge, with loans in the past, she simply tells him the cost of a loan is interest. Interest is a fee charged by the bank for loaning money.

Bonds are similar to loans; Blue Ridge is still the borrower, but the bondholder in this case would be the lender rather than the bank. Most bonds are sold in $1,000 increments, called the principal. There are several costs associated with issuing bonds:

  1. First, the bond must be underwritten. Underwriting is a process whereby the bond's price, interest rate, and maturity date are determined. Blue Ridge would need to hire an investment firm to complete the underwriting process.

  2. The next step is registering the bond with the Securities and Exchange Commission (SEC). The SEC monitors the financial health of companies issuing bonds to ensure investor confidence. Blue Ridge must gather financial data and complete the reports required by the SEC, which means that they incur the cost of reporting this information.

  3. The third cost is simply marketing the bond. Lastly, once an investor purchases the bond, Blue Ridge is contractually obligated to pay the bondholders periodic interest payments and repayment of the principal at maturity, which can be quite substantial.

George thanks Sandra for clarifying and asks her to discuss the advantages and disadvantages of issuing bonds. Sandra starts with an advantage: bonds are long-term investments and bondholders do not expect repayment of the principal for years 5, 10, 20, or 30 years. Some disadvantages include:

  • Bondholders expect annual interest payments
  • There is a legal obligation to pay interest payments and the principal at maturity
  • Negative press about Blue Ridge could decrease demand for the bonds and cause prospective investors to lose confidence

Now let's review financing with equity.

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