Final answer:
Capital structure refers to the types of funding a company uses, while cost of capital is the price of obtaining that funding. The Weighted Average Cost of Capital (WACC) is a blend of the costs of each type of funding, used as a threshold for investment decisions. Companies choose their sources of financial capital based on cost, control, risk, market conditions, and tax implications.
Step-by-step explanation:
The capital structure of a company refers to the mix of different sources of funding used to finance its overall operations and growth. This structure commonly includes a blend of debt and equity, such as bonds and stock. The cost of capital is the cost of obtaining this funding, which for debt is the interest rate paid on loans or bonds, and for equity, it is the expected return demanded by investors.
The Weighted Average Cost of Capital (WACC) represents the overall cost of capital for the company, blending the costs of each type of capital (debt and equity) weighted by their relative proportions within the capital structure. The WACC is crucial because it serves as a benchmark to evaluate investment decisions; a project is typically deemed worthwhile if its expected return exceeds the WACC.
- Financial Capital and Profits
Financial capital pertains to the funds that businesses use for investment in assets and operations, aiming to generate profits. It is closely related to profits since adequate financial capital can lead to more investments and potentially higher profits.
- Borrowing, Bonds, and Corporate Stock
Businesses raise financial capital by borrowing (incurring debt), issuing bonds (long-term debt instruments), or selling corporate stock (equity). The purpose is to have the necessary funds for investment and operations. The process involves deciding the optimal mix that minimizes costs while taking into account the company's financial strategy and market conditions.
- Choosing Sources of Financial Capital
Firms choose between sources of financial capital based on factors such as the cost of capital, the level of control owners are willing to share, business risk, market conditions, and tax considerations. The decision-making process aims to balance these factors to achieve the best financial structure for the company's goals.