The Debt vs. Equity Trade-off
A company can finance its operations in two primary ways: by issuing debt (borrowing money) or by issuing equity (selling ownership stakes). The mix of these two sources of funding is the company's capital structure. The optimal capital structure is one that minimizes the company's cost of capital and maximizes its value.
The Cost of Debt and Equity
- Cost of Debt: The effective interest rate a company pays on its debts. A key advantage of debt is that the interest payments are tax-deductible, which lowers its effective cost. However, too much debt increases financial risk.
- Cost of Equity: The return a company theoretically pays to its equity investors to compensate them for the risk they undertake by investing their capital. Equity is generally more expensive than debt because equity investors take on more risk than lenders.
Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. A company's WACC is the average rate of return it is expected to pay to all its security holders (debt and equity). Finding the capital structure that results in the lowest WACC is the primary goal. This optimal structure balances the tax advantages of debt with the financial risk of taking on too much leverage.
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