The Capital Structure Decisions and the Cost of Capital

Finance plays a pivotal role in the day to day operations of a company
from inception to winding up. Every process in between is affected by
the availability or lack of funds. Financial decisions are the most
significant yet sensitive to make because the future of a company is
pegged on these decisions. Sometimes a corporation may not be crippled
by aggressiveness of its competitors, but by the capital structure, and
the financial decisions it adopts. Corporations realize that success in
the corporate sector depends on sound financial decisions which are used
as a rubric for measuring the prudence of such an entity. These
financial decisions are made by the people who run these corporations
though there is no clear manner or consensus of how decisions should be
made, it is popular belief that their creativity should bring the
desired results some do and some fail.
Financial decisions revolve around the cost of capital whether borrowed
or generated internally. The trend in the corporate scene has been that
most company’s source for funds externally but before making such a
decision, there is the return on capital to think about there is the
market forces of demand and supply to think about, as well as, asset
base and investor relation. Classic expressions have been derived from
the works of Harris and Raviv (1991) alongside Wessel and Titman (1988)
view on empirical facts for capital structure decisions. These are only
considered after internal sources of funds are depleted and external
borrowing is the last resort. In finance, the general practice and
rationale is that internal financing is cheaper compared to debt, which
is external, in terms of cost of acquiring the funds. The key driver of
financial decisions is the cost of capital it affects the form of
capital structure the organization adopts. The capital structure in this
case involves the proportions of various sources of finance used which
include equity and debt. It is not just enough to source for funds, but
it is also necessary to comparatively and decisively analyze each source
and its cost of capital to determine its effect on return on interest,
return on investment, as well as, the overall effect on the price of the
company`s stock both in the long term and shorter to achieve this
financial analysts use both weighted average cost of capital and
marginal cost of capital approaches. This paper will dwell on the role
of financing decisions and the effects of capital structure on current
and future operations of the company.
1) Based on the readings of the Module, and upon reviewing total
debt/equity ratios, company betas, profitability ratios, company
revenue, assets, and liabilities, and the nature of the operations of
the companies including the nature of their customers and products, what
would you recommend should the capital structure (total liabilities or
debt and equity proportions) be for each of the three companies? 
Capital structures
Sometimes it is tricky in trying to come up with an optimal capital
structure, but this does not mean the ideal should be abandoned
altogether. This section will look at each company`s statistics to
propose the optimal capital structure. The optimal capital structure
deals with the right proportion of each source of funds in the capital
structure of a company. The aim of maintaining an optimal capital
structure is to ensure a company`s survival.
The optimal capital structure
EBay is an online outfit that specializes in online business. Most of
its operations are carried out on the online platform through
E-commerce. Its largest assets may be cash thereby lacking an
established asset base: as such, the company cannot rely so much on debt
in its capital structure because providers will require collateral which
in this case is not available. However, this is not to say that the
company cannot expand its operations. As a matter of fact it can by
utilizing more equity, and bonds in its capital structure as opposed to
long-term debt.
Following that eBay Inc has an attractive earnings multiple of 26.60,
investors are therefore expecting higher earnings from their
investments. Additionally, it can also be interpreted that an investor
is willing to pay $26.60 for every $1 earning. This goes without saying
that, it would be easy to raise funds through equity as investors would
look at the price earnings ratio, as well as, the current ratios.
The increase in the number of customers points to the fact that the
revenues of eBay have increased. Irrespective of the slight decline in
operating margin, from 21.9%-22.3%, the activities of the company are
still profitable. This factor that could fetch the company more
investors for its equity shares, thereby, making it possible to raise
additional capital.
The Clorox
The Clorox Company is a stock dealer: it sells and transfers shares to
prospective investors it, therefore, acts as a brokerage firm. The
Clorox Company has a considerably lower beta ratio of 0.38 compared to
that of the market which is 1.0. A higher beta indicates higher cost of
equity, as well as, high stakes and not to mention high rate of return
while vice versa is true. A company such as the Clorox cannot use large
amounts of equity in its capital structure (yahoo finance, 2013). This
follows that the investors will shy away from buying its equity stock
due to the low rate of return. Beta is the best quantifying parameter
applied in calculating the cost of equity used in discounting cash
flows. Despite all factors indicating that the cost of equity may be low
compared to that of eBay, which has a beta ratio of 0.96, high debt
proportions in the capital would be appropriate in this case.
Looking at The Clorox`s ratio of return on assets it indicates that the
company`s rate of converting its investment to income is low. Holding
other factors constant, it is assumed that would be investors, must look
at the company`s ROA thus they would not go for the company’s stock.
This means that it would be difficult for the company`s to raise
additional capital through equity, therefore, a higher proportion of
debt in the capital structure would be appropriate in this company`s
Alaska air group Inc
It is a holding company for Horizon air and Alaska airlines. Its main
activities revolve around managing the operations of the two airlines
with more than 80 passenger destinations. Capital requirements for this
company is quite tasking because it requires a lot of funds. The company
has a beta of 0.82 which indicates that it has a high rate of return on
investment, as well as, a high cost of capital. This means that the
investors will be looking forward to buy its equity stock. Additionally,
the company`s price earnings ratio stands at 12.98 meaning the investors
expect the earnings to grow at that rate (Yahoo finance, 2013). The
company lacks an adequate asset base, and as such, borrowing would not
be a good idea. Additionally, the company`s return on assets is
significantly low because it stands at 6.89%. This means that high debt
proportions in the capital structure will be hefty to the company.
Though the cost of equity may be high it still remains the best shot for
the company, and as such, the company should use large equity
proportions in its capital structure as opposed to debt and bonds.
2) What do you perceive you have learnt in Module 4 Case Assignment?
Which of the following learning objectives do you feel you have
Discuss the advantages and disadvantages of debt financing and of equity
Advantages and disadvantages of debt financing
Use of debt in the capital structure of a firm allows the owner to
maintain control over the assets of the firm which would not have been
possible had the owner invested their own funds (kokemuller, 2013).
Prospective investors can use gearing ratios to measure the riskiness of
the firm.
The interest paid is an allowable expense for tax purposes. This is an
added advantage because the firm can use these funds in other investing
A low interest debt may prove cheaper than equity in the long run thus
saving more earnings which are paid out to the shareholders. This gives
the firm and its equity holders a chance to invest in growth.
Debt involves fewer formalities compared to equity which involves
standards of practice.
Disadvantages of debt financing
The borrower is under an obligation to pay interest on monies borrowed.
This interest accumulates whether profit is made or not.
Use of debt increases the firm`s level of risk. This means that the
company can fall apart easily.
Use of debt requires a pledge of the firm`s assets as collateral meaning
one loses the right those assets until all debt is paid up.
Equity financing
Advantages of using equity financing
The firm is under no obligation to pay the dividends that accrue on
equity stock.
The process of selling equity stock through the prospectus offers the
firm a chance to market itself.
In case of an incorporated firm it is possible to spread and diversify
risk over a large number of investors.
Disadvantages of equity financing
It is easy to lose control over the assets due to dilution ownership of
the firm this creates conflicts which is discussed in the theory of the
There are laws governing the issue of equity stock which require total
compliance lest a firm is wound up.
The firm must always act in the best interest of all shareholders
whether the controlling interest or the non-controlling interest as
opposed to personal or individual ambitions.
A firm’s optimum capital structure does not involve a single component
of a source of funds, but various sources in the right proportions. A
company with an optimum capital structure is able to withstand tough
economic times, as well as, reap maximum benefits.

Harris, M and Raviv, A. (1991). Journal of finance 46:1 retrieved on
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Yahoo finance (2013). The Clorox Company (CLX)-NYSE. Retrieved on 12th
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Yahoo finance (2013). Alaska Air Group, Inc. (ALK)-NYSE. Retrieved 12th
mar 2013. Retrieved from HYPERLINK
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Kokemuller, Neil (2013). The Major Advantages of Utilizing Debt in a
Firm`s Capital Structure. Retrieved on 12th march 2013 retrieved from
ital-structure-19002.html .