Chapter 3: Capital Structure and Cost of Financing

3.1. Definition of Finance

In relation to capital structure, finance can be defined as the process of raising money or capital to meet certain types of expenditure. For example, finance in government may include tax revenue and debt used to fund development projects. In a company, finance involves raising funds from sources such as equity, bank loans, and retained profits to fund business operations and investments.

Business people, government departments, organizations and consumers are not always endowed with enough resources to meet their expenditure, pay debts and complete other transactions. There are also savers and investors accumulate their funds in interest-earning deposits, shares, shares, or insurance claims.

Finance is the process of channeling these funds through loans, equity capital, or credit to economic entities or companies that need them and can put them into productive use. The institutions that facilitate this process of financing various entities are referred to as financial intermediaries. They connect borrowers with lenders to ensure that funds are channeled to areas that need them the most.

The three broad areas of finance are:

  • Personal Finance: concerned with how individuals acquire and use funds through personal savings, expenditure and investment.
  • Business Finance: concerned with how companies or business entities acquire and spend money for various business operations and investments.
  • Public Finance: This covers government spending and other ways in which governments manage public funds raised though taxation, internal borrowing, and external borrowing.

3.2. Meaning of Capital Structure

Capital structure refers to the mix of equity and debt that a company uses to finance its operations and assets. For a company to continue operating normally while still growing, it needs capital. This comes primarily from debt or equity or both. Some of the advantages of using debt financing include: (1) debt interests are tax deductible, while dividends from shares are not deductible; this lowers the overall cost of debt. (2) Debt has a fixed return, such that the company does not need to share profits with shareholders.

Debt as a source of financing also has several disadvantages: (1) It increases risks for the company, and (2) the bank may go bankrupt if it is not able to repay its debts during hard economic times.

Companies that have relatively little business risks can use more debt, but if the business operates in a risky and volatile environment it should minimize the use of debts to finance its operations.

When Safaricom entered into a licensing deal to enter Ethiopia in 2022, it had the decision to use either equity or debt to finance its operations in Ethiopia. The company did not have enough reserves to invest in the project, but it was able to borrow a bank loan of $400 million to finance the project. By September 2022, Safaricom’s total debt amounted to KSH76.9 billion, against cash and cash equivalents of KSH26.4 billion. Within the same year, the company had a total of KES139.5 billion. This shows that the company has more equity than debt in its capital structure at 64% equity and 36% debt.

Due to the high equity investment and huge profits, Safaricom has been paying 80% of its net income to shareholders as dividends, while 20% is reinvested in infrastructure and retained earnings.

An optimal capital structure refers to the structure which enables a company to maximize stock price. Some companies have a target capital structure of 45% debt and 55% equity; others that have a stable business can take 60% debt and 40% equity. The trade-off theory of capital structure suggests that managers should seek an optimal mix of equity and debt that minimizes the firm’s weighted average cost of capital, which in turn maximizes company value. An optimal capital structure seeks a balance between the cost-effectiveness of borrowing and risk minimization of equity.

3.3. Determinants of Capital Structure

Determinants of capital structure are the factor that affect the decisions of a finance manager when choosing the mix of equity and debt to finance their operations and assets. Several qualitative and quantitative factors affect the firm’s capital structure.

  • Leverage: this refers to the use of debt to finance an investment or business operations. A company that uses more debt in its capital structure is said to be having high leverage.
  • Business Growth and Stability: A company that is operating in a relatively stable environment can use more debt to finance its assets and operations. If the company’s sales and growth are not predictable, using debts will increase the firm’s risks. Stability in sales ensures that the company is able to meet its financial obligations and fixed costs even during hard economic times.
  • Cost of Capital: Cost of capital refers to the minimum returns expected by the providers of finance such as banks and investors. The expected return depends on the degree of risk as estimated by the investor or bank. A company’s capital structure should give provide the least cost of capital; the company should focus on minimizing the cost of capital. In other words, the company should have a capital structure that minimizes the cost of acquiring funds.
  • Risk: When planning a company’s capital structure, two sources of risks must be considered: business risk and financial risk. Business risk occurs when earnings vary – the risk of not getting the earnings the organization expected. Poor strategy, low demand, and low quality products can contribute to reduced earnings; hence causing business risks. As a general unwritten rule for managers, debt capital should be reduced where business risks are high.
  • Cash Flow: The amount of cash inflows versus outflows determine the choice of components within the capital structure. A more conservative approach uses less debt in the capital structure to ensure that the firm does not incur fixed charges that may affect their cash flows. Therefore, before a company thinks about raising more capital, it should first assess its cash flows and ensure that it will be able to generate more cash flows in the future to pay for the fixed charges.
  • Nature and Size of the Firm: the size of the firm is also an important determinant of capital structure. Large companies basically use equity financing due to its ability to attract investors. Furthermore, large companies have more flexibility to choose between debt and equity because they can easily obtain long-term loans. It is difficult for small firms to raise long term loans. The nature of the company also determines the company’s capital structure. Public entities often have more stability, so they can employ more debt in their capital structure.
  • Control: Another important determinant of capital structure is control. A company looking for financial capital considers the level of control that each option offers. Equity funding leads to significant loss of control over the firm, but debt financing does not make the management to lose control of the company. Thus, managers create a capital structure by considering their need for control in the business.
  • Flexibility: Flexibility means the firm’s ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalisation or sources of funds. Whenever needed the company should be able to raise funds without undue delay and cost to finance the profitable investments.
  • Market Conditions: Market conditions, including inflation and timing can also be good determinants of a firm’s capital structure. When there is depression, debt financing may not be appropriate. The company may also be unable to raise investment funds through shares when the business is not doing well as a result of a depressed economy.

3.4. Concept of Cost of Finance

The cost finance refers to the price that a company pays to obtain financing for their business operations and assets. It is also called financing cost or cost of capital. Businesses and financial analysts use the cost of capital to determine if funds are being invested effectively. If the return on an investment is greater than the cost of capital, that investment will end up being a net benefit to the company’s balance sheets. To get finance, a company must incur implicit costs, which are often referred to as floatation costs. Financing cost or cost of finance refers to the costs, interests and other charges involved in raising finance to purchase assets or run business operations. Costs of finance include underwriting commission, brokerage costs, cost of printing a prospectus, commission costs, legal fees, audit costs, and cost of printing certificate shares. There are also certain costs incurred when obtaining debt financing such as legal fees, valuation costs, banker’s commission, audit fees, etc.

The cost of finance is often influenced by security, credit rating, timing, and availability. Short term finances incur costs such as interest charge on loans. Banks often offer loans at fixed charges as interests, which are calculated as a percentage of the loan value. For example, a company that borrows KSH10 million at an interest rate of 10% will have to pay KSH1 million in addition to the principal amount. A bank overdraft also incurs annual maintenance fee on top of the interests charged. The interest charged on any type of short term loan varies based on the risk of default.

Interest is also the primary cost of a long term loan, which is lower if the loan is secured. Arrangement and maintenance fees, insurance, and transaction costs are also some of the costs associated with a long term loan. Equity finance also incurs costs such as flotation costs, which include the legal fees paid to financial advisers. A company looking for listing in a stock market requires the services of a corporate adviser, stockbroker, corporate lawyer, accounting, and public relations firms. These advisers charge significant fees for the company, which is then considered to be part of the financing costs of the company. Further direct costs of listing are the admission and annual fees payable to the stock market. The admission fee is based on the market capitalisation of the company on the day of admission while the annual fee is fixed for all companies.

3.5. Importance of Cost of Finance

The cost of finance or cost of capital is used by managers to make important decisions regarding investments and business operations. It is important for various reasons:

  • Evaluating Investments/Capital budgeting decisions: The cost of capital is used in various methods of evaluating investment projects such as IRR and NPV. In regards to the NPV method, cost of capital is used to calculate discounted cash flows and compare cash inflows and outflows. In terms of IRR, managers choose projects that have a higher internal rate of return than the cost of finance.
  • Designing Capital Structure: The cost of finance is one of the most effective factors used in designing an optimal capital structure of a company. While designing a capital structure, the company considers the maximizing the value of the firm and minimizing cost of finance. By comparing the costs of different sources of capital, the managers can choose the least expensive methods and design an optimal capital structure.
  • Evaluating Financial Performance: Companies can use the cost of finance or cost of capital concept to evaluate the performance of various investment projects. This includes comparing profits and costs of particular projects. The importance of cost of finance is that it allows the company to calculate its financial performance in terms of profits and costs.
  • Creating Debt Policy: Firms consider the cost of finance to create the right debt policy which ensures that the company has the right leverage. Excess debts may cause harm to shareholders’ wealth. The cost of capital is also used to determine the right proportion of debt and equity for the company.
  • Choosing the Method of Investment: Financing costs can be used to compare different methods of raising finance. For example, the costs of leasing and borrowing can be compared to choose one of the two methods which incurs less costs than the other.
  • Performance Appraisal: Another important use of cost of capital is to carry out performance appraisal – evaluating the performance of top managers. In this case, the appraisal of actual costs is carried out and compared to profitability. If the company has more profits than costs from financing, then the managers have made the best choices.
  • Dividend Decisions: Another importance of cost of capital is to make decisions regarding dividend payments. Firms create dividend policy based on the returns and costs of their investments. A company that incurs high costs of finance may have little profits to pay as dividends.

3.6. Components of Cost of Capital

Cost of capital refers to the rate of return that a firm needs from its investments to maximize its value. The Cost of Capital consists of two categories:

  1. Cost of Equity

This refers to the cost of leveraging financial capital or equity provided by shareholders, which are repayable in capital gains and higher share price. The cost of equity can be determined using the dividend price approach or the earning price approach.

The dividend price approach involves calculating the expected future dividend payments. In this approach, the cost of equity refers to the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. The cost of equity using dividend price approach can be calculated as follows:

KE = (Dividend per share / Market price per share) x 100; where:

  • KE = Cost of Capital

On the other hand, the earning price approach is used to calculate the future stream of earnings from shareholders’ investments. The formula for calculated the cost of equity using the earning price approach is given as:

KE = E / MP; where:

  • E = Earnings per share
  • MP = Market price
  1. Cost of Debt:

This is the cost incurred when borrowing funds from a bank or financial institution for investment purposes. The financing institution recovers its principal amount and earns profit by charging interest on the borrowed amount. This interest contributes to the total cost of debt. The cost of debt when issued at par is calculated as follows:

KD= [(1 – T) x R] x 100; where

  • KD = Cost of Debt
  • T = Tax Rate
  • R = Rate of interest on debt capital

When debt is issued at premium, the cost of debt can be calculate as follows:

KD = [1 / NP x (1 -T) x 100]; where:

  • KD = Cost of Debt
  • NP = Net proceeds of debt
  • T = Tax Rate
  • R = Rate of interest on debt capital


  1. Cost of Preference Capital:

The cost of preference capital refers to the sum of dividends paid and expenses incurred to raise preference shares. The dividend paid on preference shares is not deducted from tax, as dividend is an appropriation of profit and not considered as an expense. Cost of preference share can be calculated as follows:

Kp = [{D + F / N (1 – T) + RP / N} / {P + NP / 2}] x 100; where:

  • KP = Cost of preference share
  • D = Annual preference dividend
  • F = Expenses including underwriting commission, brokerage, and discount
  • N = Number of years to maturity
  • RP = Redemption premium
  • P = Redeemable value of preference share
  • NP = Net proceeds of preference shares

3.7. Weighted Average Cost of Capital (WACC)

Definition of WACC

The Weighted Average Cost of Capital (WACC) refers to a firm’s average cost of finance from all sources including equity, preferred shares, and debt. It can also be defined as the average rate of return that is expected to be paid to stakeholders, debt holders, and preferred shareholders. Another definition of WACC is: the weighted average cost of a company’s equity and debt. One of the assumptions of the WACC is that the market for debt and equity requires a rate of return that reflects the investment risks of the company.

Example: Suppose a company’s CEO goes to the bank and requests for a loan. The company agrees to lend the money at an interest rate of 10%, which means the firm has to pay an interest above the principal amount borrowed. This is called “cost of capital or cost of debt.” When the company grows, the company decides to offer shares to investors to raise additional funds. The firm has to pay dividends and flotation costs incurred through shares. This is also part of the cost of capital, and is known as cost of equity. A company that has more than one source of capital needs to calculate the weighted average cost of capital.

Formula for Calculating WACC

The Weighted Average Cost of Capital can be calculated as follows:

WACC Formula = (E/V × Re) + (D/V) × Rd × (1 – Tax rate); where:

  • E = Market Value of Equity
  • V = Total market value of equity & debt
  • Re = Cost of Equity
  • D = Market Value of Debt
  • Rd = Cost of Debt
  • Tax Rate = Corporate Tax Rate

Components of WACC

These components of the WACC are explained as follows:

  • The market Value of Equity refers to the total value of shares offered by the company. for example, if a company has 10,000 shares, each valued at a market value of KSH5, the market value of the company’s equity is 10,000 × KSH 5 = KSH 50,000.
  • The market value of debt is the total amount of debt that the company has borrowed from various sources.
  • Adding the market value of debt and market value of equity gives us the total market value of equity and debt.
  • Cost of equity: the minimum return that shareholders demand
  • Cost of debt have been explained earlier. Refer to section 3.6.
  • Corporate Tax Rate: The cost of debt needs to be adjusted to reflect that interest payments are tax-deductible. A company’s tax rate is primarily determined by where it operates.

Example of Calculating WACC

Assume Company A has a market value of debt of KSH 1 million and market value of equity (market capitalization) of KSH 4 million. Further assume that the cost of equity is 10%, cost of debt is 5%, and tax rate is 25%; calculate the WACC.

WACC = [(E/V × Re)] + [(D/V) × Rd × (1 – Tax rate)];


First calculate V (the total market value of debt and equity):

V = 4 million + 1 million = KSH 5 million.

WACC = [(4/5 × 0.1)] + [(1/5) × 0.05 × (1-0.25)]

WACC = 0.08 + 0.0075

WACC = 0.0875 or 8.75%

To interpret this, the company needs a minimum rate of return of 8.75% from its investments to be able to give returns to finance providers.

NB: The first part of the formula represents the weighted average cost of equity (E/V × Re); while the second part represents the weighted average cost of debt [(D/V) × Rd × (1 – Tax rate)]. When you add the two parts you get the weighted average cost of capital (WACC).

Uses of WACC

There are several uses or importance of WACC in a company.

  • WACC is used as the discount rate when calculating the net present value (NPV). This means that it is used in financial modelling.
  • Used as the hurdle rate when analyzing investment projects
  • Used to calculate a company’s opportunity costs
  • Used to make dividend decisions – whether to pay dividends to shareholders or not.
  • Calculation of the economic value added (EVA)
  • WACC is also used for the valuation of the company
  • It is used to create optimal capital budgets.

3.8. Formulation of Capital Structure Policy

A capital structure policy is a set of guidelines and targets established by a company’s management to determine the proportion of debt and equity in their capital structure. Policies of capital structure may specify the following:

  • The percentage of debt and capital equity: some companies choose a zero debt policy in which the firm uses only 100% shareholders’ equity to fund their operations and investments. Other companies may require 40% debt or more, depending on the company’s financial needs and market conditions.
  • Borrowing limits of the firm: a capital structure policy may also specify the limits of using debt as a source of capital. It states the maximum amount of debt that can be allowed in the company. For example, the company’s policy may limit its debt to 40% of the total capital.
  • Preferred debt-equity ratio: Debt-equity ratio may also be used to specify the proportion of debt and equity in the capital structure. For example, a company may choose a debt-equity ratio of 1:1 when pursuing a moderate growth strategy. Most firms use a debt-equity ratio of 2:1, which allows the company to borrow twice as much money as it raises through equity.

Capital structure policy is a conscious decision making process involving a company’s management. It ensures that the company sets rules to create the right balance between debt and equity financing. A capital structure policy that is too aggressive may result in too much borrowing, which leads to unmanageable debt and financial distress. It provides targets of the firm with regards to debt and equity mix, which must consider the company’s strategy and prevailing market conditions.

3.9. Dividend Policy and Capital Structure

Dividend policy has a direct connect with the concept of capital structure. Dividend policy is the policy that a firm uses to determine its dividend payout to shareholders. It establishes the conditions under which dividends can be paid, and how much dividends must be paid in particular situations. For example, Safaricom has a dividend policy that requires them to pay out 80% of their profits through dividends to shareholders. This is a generous dividend policy which allows shareholders to get a large proportion of the company’s earnings as dividends. Management must decide on the dividend amount, timing, and various other factors that influence dividend payments.

Types of Dividend Policy

There are three types of dividend policies: a stable dividend policy, a constant dividend policy, and a residual dividend policy.

  • Stable Dividend Policy: A stable dividend policy involves steady and predictable annual dividend payments. Whether earnings increase or decrease, investors are assured of a dividend every year. This is the easiest and most common dividend policy. It aligns the company’s dividend payments with the long term growth of the firm, rather than focusing on short term fluctuations of earnings. The advantage of this policy approach is that it enhances certainty to shareholders in terms of amount and timing. However, the disadvantage of this policy is that shareholders will not get an increase in dividends even when earnings have increased.
  • Constant Dividend Policy: This type of dividend policy enables the company to pay a certain percentage of its earnings as dividends to shareholders every year. Thus, dividend amounts increase when earnings increase. The problem of this approach is volatility, which prevents the firm and its shareholders to plan their financial matters.
  • Residual Dividend Policy: Under the residual dividend policy, investors get as dividends whatever remains after the company pays for capital expenditures and working capital. This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justifies its increased debt with the need to pay dividends.

3.10. Influence of Taxation on Financing Decision

Tax is an important factor to consider when making corporate financing decisions. If a company is financed by debt capital, there will be tax relief available on interest payments. Alternatively, if the company is financed with shareholders’ fund (that is equity capital), then dividend will be paid on the equity from the profit after tax, which will in turn give rise to a liability for income tax.

If corporate interest payments are priced as if they are untaxed at the personal level, a 50 percent corporate tax saving on interest deductions can make the cost of debt as little as half that of equity, even when the equity pays no dividends. In short, good estimates of how the tax treatment of dividends and debt affects the cost of capital and firm value are a high priority for research in corporate finance. The corporate and individual income tax can play a significant role in the investment, financing, and dividend decisions of the firm. In terms of the corporate income tax, distributions to fixed income securities are generally deductible in computing taxable income, while distributions to residual claims are not.