Capital Structure and Cost of Capital

The most widely accepted view of management’s overall financial objective, the maximisation of the value of the enterprise to its owners, was shown to involve the formulation of policies for the three main areas of investment choice, capital structure and dividend policy. It argues that the capital structure decision impinges on both investment decision making, through its effect on the firm’s cost of capital and on dividend policy through its effect on the size and risk of dividend prospects. The theoretical debate on the importance of capital structure can easily take on an appearance of abstract unreality, given that it is often conducted in the context of static or comparative-static analysis of the firm and in terms of a drastically simplified choice between financing methods. Capital structure theory is concerned with the question of the existence of an optimum capital structure in the sense of a mixture of types of long-term finance that maximises the wealth of a firm’s shareholders.