Muhammad Abbas Class Id# 11058

Impact of Capital Structure on cost of capital

1. Introduction
In this paper we tried to evaluate the impact of Capital structure on Firm’s Financial
Performance and Shareholder’s wealth. In this paper we use two dependent variables
(Firms performance, Shareholder's value) to investigate the one independent variable
(Capital structure). We tried to analyse the determinants of capital structure and find out
the optimal capital structure that increase the value of the firm’s financial performance
and shareholder's wealth. First we have to analyse that what it means by Capital
Structure.
Capital structure of a firm is referred to the Firm’s financing through different sources like
Equity (Common and Preferred Equity) and Debt (Short-term and Long-term). Firm’s
calibrate its debt option for financing its operations by issuing bonds to the general public
having the specific prescribed interest rate or taking loan from the banks in the form of
notes payable which classified as long-term debt, another option to finance firm’s
operations is from equity source by issuing common stocks and preferred stocks to the
general public. Capital structure of a firm also includes short-term debt in shape of
working capital requirements of the firm.
Capital structure refers to as the organizations mix of debt and equity financing as they
finance their funds for investment from two sources either to take loan from the bank
called debt or issue their shares to general public called the equity financing. According to
Saleem (2013) Capital structure of a firm is defined as the various financing alternatives
of its assets used by the firm. The combination of debt and equity to finance firm’s long-
term assets is stated as capital structure of the firm. Debt and Equity are the basic
components of the firm’s capital structure.
According to Lim (2012) The way firm generate the money to finance its operations and
in what way it assigns these financing options that he choose to its balance sheet is
referred to Firm’s capital structure. It represents the total capital of a firm in terms of debt
and equity combination to finance firm’s operations. According to San & Hang (2011) in
order to finance firm’s overall operations and growth by financing its assets from various
sources is dependent upon capital structure of the firm.
According to Umar (2012) Debt and Equity is the main financing options used by all the
firms. For the purpose of operating a firm, intensity of debt or equity option used by the
firm to finance its operations represents the firm’s capital structure. If the organizations
are financing through debt they have to pay the interest to the banks and if they are
financing through equity they have to give the dividends to the shareholders from their
profit and sometimes generate the retained earnings account that they did not distributed
to the shareholders but reflecting their profit. We use the secondary data in our research
in the shape of Firms Financial Performance measures in accounting terms like ROA and
ROE ratios and Shareholders wealth accounting measure like EPS of the firms.
Muhammad Abbas Class Id# 11058

Modigliani and Miller (M & M) (1958) wrote a paper on the irrelevance of capital
structure that inspired researchers to debate on this subject. This debate is still
continuing. However, with the passage of time, new dimensions have been added to the
question of relevance or irrelevance of capital structure. M&M declared that in a world
of frictionless capital markets, there would be no optimal financial structure
(Schwartz & Aronson, 1979). This theory later became known as the"Theory of
Irrelevance'. In M & M's over-simplified world, no capital structure mix is better than
another. M & M's Proposition-II attempted to answer the question of why there was an
increased rate of return when the debt ratio was increased. It stated that the
increased expected rate of return generated by debt financing is exactly offset by
the risk incurred, regardless of the financing mix chosen.

1.1 Problem Statement

 It is quite problematic to design specific general Optimal Capital Structure for
the firms that maximize the firm’s performance, profitability and Shareholders
wealth regardless of their size and other factors.
 The decision about the capital structure having the danger of violating Agency
cost theory in our Capital Structure Decisions we have to select the best
possible Capital Structure.
 The optimal Capital Structure in different countries and in different economies
has different ratios that contribute in the problem of analysing their impact on
firm’s performance, Profitability and Shareholders wealth.

1.2 Research Questions

1. What is capital structure and cost of capital?
2. How capital structure impact on a cost of capital?
1.3 Research Objectives
1. To identify proportion of debt and equity.
2. To identify impact of debt-equity ratio on firm value.
3. To analyse the rate of return and risk associated with capital.
4. To evaluate the weighted Average cost of Capital.
5. The correlation between capital structure with rate of return and earning per
share.