In a world where everything revolves around finance, there is no doubt in saying business decisions are always financially based whether it is a profit or non-profit organisation. Finance in the form of capital is what determines the beginning of a business whether it is a large or small corporation. However the bottom line is, capital is what runs and keeps the business going, but what is the consequential side of obtaining that source of finance? There are at least two sources of capital, Equity and Debt, and both are affected by the level of risk, meaning the implication of gearing within a capital structure.
Equity financing is a means of obtaining capital from shareholders, whilst Debt financing is a means of obtaining capital via borrowing and is viewed as a cheaper method of obtaining finance than Equity. The risks involved in these methods of finance is determined by an indicator known as gearing. Dependant on the level of gearing as well as the level of debt, this affects the overall WACC and this determines the level of rate of return a firm receives based on the investment it finances.
Without one knowing the real methods used in obtaining capital to finance prospective investments, one might think it is quite simple to choose which investment is more appropriate based on how lucrative the future of the investment might be and ignoring other factors such as the cost of capital. Businesses with strategic visions of growth really do play around with their capital structure to ensure the best method is always favourable to their organisation by providing them not only with good returns but also maximum shareholder wealth. It is now understandable as to why high importance is given to capital structure as any mistakes done will have a dramatic effect on the organisation as a whole and the hope of the shareholders will be shaken. With this in mind, careful financing of debt with the right level of gearing ensures financial security.
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