Impact of Cost of Capital on Capital Structure

Question: Discuss about theImpact of Cost of Capital on Capital Structure. Answer: Introduction The cost of capital of the firm Etisalat is considered as the requisite return that is necessary for making any project on capital budgeting (for example: opening of a new factory). Etisalats cost of capital is comprised of cost of debt along with cost of equity and it has been found that the particular firm uses common equity, debt and preferred equity for funding its new projects (Brigham Ehrhardt, 2013). Therefore, it can be said that the decision regarding capital budgeting might affect the companys capital structure and in return it can also affect the cost of capital and also vice-versa. It has been found that the total debt of the company Etisalat was AED 22229 million in 2014 and it slightly reduced to AED 22080 million in 2014 ("Etisalat.com ", 2016). On the other hand, total equity of the organization reduced from AED 60214 million in 2014 to AED 59375 million in 2015 ("Etisalat.com ", 2016). Thus, the objective of Etisalat has been found to maximize its shareholders retur n and stakeholders benefits and to maintain an optimal capital structure for reducing its cost of capital. As a result, the topic that has been selected for the research proposal is for identifying the affect of cost of capital on the capital structure of the particular firm. Theoretical Background (Literature Review) Capital Structure and Cost of Capital The capital structure is defined as a process by which an organization finances its total operations as well as regulations and growth by utilizing various fund sources. It has been found that debt is considered as one type of long-term notes payable or bond issues and on the other hand, equity is differentiated into preferred stocks, common stocks and retained earnings. Moreover, the working capital requirement that is considered as short-term debt is also counted as a portion of capital structure. An organizations capital structure might also be a mixture of common equity, long-term debt, preferred equity and short-term debt. The percentage of long-term and short-term debt is also counted when the firms capital structure is analyzed. However, as per Brigham Houston (2012), the firms capital structure is referred to the debt to equity ratio of the company as this provides imminent regarding the riskiness of the firm. According to Dorfman Cather, (2012), the companies that are heav ily financed by debt are considered as the firms that possess more risk from the viewpoint of the investors. Therefore, investors avoid investment in the companies having high debt as it is much riskier for the investors. Factors Affecting Cost of Capital As per Titman, Keown Martin (2015), there are various factors that affect the cost of capital and can also be controlled by the firm itself. These include changes in the policy of the capital structure, changes in the firms dividend policy and investment policy. On the other, Finkler et al. (2016) stated that there many other aspects that have an effect on the firms cost of capital but cannot be controlled by the organization itself. These include level of interest rates and taxation rates. It has been found that with the change in the cost of equity, the interest rate and the cost of debt get affected. On the contrary, with the rise in the tax rate, the cost of debt falls along with the cost of capital. Relationship among Cost of Capital, Value of the Firm and Capital Structure Opined to Oikonomou, Brooks Pavelin, (2012), the relationship between the capital structure, the value of the business and cost of capital can be better understood through the implementation of four principal theories. These include Net Income Approach, Traditional Approach, Modigliani-Miller Approach and Net Operating Income Approach. Each of these theories presents different views on the relationship between the utilization of the common stock value and financial leverage. However, as per McKinney (2015), these theories vary in considering the capital structure decision to the business value. The net income approach is known as the dependence theory and here WACC and share price both are influenced by the financial decision of the firm. However, the net operating income approach is opposite to NI approach. The traditional approach lies in between these NI approach and NOI approach. Lastly, as per Modigliani-Miller approach, the common stock price and cost of capital of a firm are considered as independent of the degree for which a firm opts for using financial leverage. Research Methodology Purpose of the Study The rationale of the particular study is to determine the affect of cost of capital on the capital structure of the firm Etisalat, such that proper measures can be taken in order to sustain an optimal capital structure within the firm. In addition to this, it can also be said that Etisalat monitors the financial market and updates them to the approaches of standard industry in order to compute the weighted average cost of capital (WACC) (Molina Preve, 2012). Therefore, the other aim of the study is to monitor and study that the average cost of capital of the particular organization is independent of its capital structure or not. Moreover, it can also be said that the purpose of the study is to determine whether the earnings/ price ratio increases the linear alliance of the economic risk as per the ratio debt to equity. Scope of the Study The research study puts emphasis on the collision of cost of capital on the capital structure of Etisalat. It has been found that as per the annual report of the organization Etisalat for the year 2015, the cost of capital of the firm was high and thus it had negative effect on it. Therefore, the board of directors of the particular firm decided to monitor the cost of capital and to reduce it in order to attain an optimal capital structure (Melicher Norton, 2013). Moreover, from this study, the relationship between the weighted average cost of capital (WACC) and the financial markets can also be studied and analyzed in detail. Additionally, the effect of earnings/ price ratio on the linear function of financial risk has also been analyzed in this research work (Jovanovic Schinckus, 2013). Therefore, the study on Impact of Cost of Capital on Capital Structure of the company Etisalat can be considered as an important and useful topic for the research work. Sources of Data The data can be gathered from the annual report of the particular firm Etisalat, website of the company, related books, journals, articles, websites and many more. Therefore, it can be said that all the data and information for the particular research work can be gathered from the secondary resources only. The dissertations, journal articles and the research papers relating to financial management, capital structuring and cost of capital that have been studied by the previous authors will act as the main source for data collection (Griffin Pustay, 2012). Hypotheses of the Study Hypothesis Number 1: H0: The cost of capital does not have any impact on the capital structure of Etisalat. H1: The cost of capital has impact on the capital structure of the firm Etisalat. Hypothesis Number 2: H0: The weighted average cost of capital does not have relationship with the financial markets. H1: The weighted average cost of capital has relationship with the financial markets. Hypothesis Number 3: H0: Earnings/ price ratio does not have any effect on the linear function of financial risk. H1: Earnings/ price ratio have effect on the linear function of financial risk. Methods and Techniques Adopted in the Research Study In the specified research study, both the qualitative and quantitative research methodologies will be implemented in order to analyze all the hypotheses in detail. Here, both the qualitative and quantitative research methodologies will be used for analyzing the data and information that have been collected from secondary resources (Dudin et al., 2014). In the particular research work, information and data will not be collected from the primary resources, as for the specified study the secondary resources will be the best option. The data will be collected from the annual report of the particular firm Etisalat, website of the company, related books, journals, articles, websites and many more. In addition to these, the dissertations, journal articles and the research papers relating to financial management, capital structuring and cost of capital that have been studied by the previous authors will also be considered as the secondary resources (Copeland, Weston Shastri, 2013). In order to study the gathered data through quantitative analysis, various mathematical and statistical tools will be implemented. These include regression analysis, correlation analysis and various other descriptive statistics. Empirical Analysis The learner can test the collision of cost of capital on the firms capital structure by studying the theoretical underpinnings through qualitative analysis and the gathered data and information from the dissertations, research papers and journals through quantitative analysis (Michalski, 2012). The quantitative analysis includes the mathematical and statistical tools like regression analysis, correlation and other descriptive statistics. It has been found that there is no accurate standard or limitation for cost of capital by maintaining which an optimal capital structure can be maintained within a firm. However, by maintaining the debt-to-equity ratio of the organization, business value can be maximized and by balancing between the ideal debt-to-equity ranges, the organizations cost of capital can be minimized with the intension to achieve an optimal capital structure of the firm (Danthine Donaldson, 2014). In other words, it can be said that by optimizing the shares market value a s well as the companys cost of capital, an optimal capital structure can be attained. Conclusion Therefore, it can be concluded that by performing the research study in an orderly and systematic manner, the entire research work can be done properly. Additionally, with the implementation of proper research methodologies, the hypotheses can also be analyzed in detail. Moreover, the literature review and the theoretical underpinnings of the research study will also help to perform the entire work. In addition to these, both the quantitative analysis and qualitative analysis methods of studying the data gathered from the secondary resources will also help to understand and conclude the problem statements as well as the hypotheses of the particular research. Recommendation Thus, it can be recommended that there is no fixed benchmark or standard for ideal structure of cost of capital in an organization. Therefore, the firm Etisalat should optimize the market values of its shares and cost of capital in order to maintain an optimal capital structure within the firm. In addition to these, the firm should maintain a balance between debt-to-equity range and the cost of capital of the organization should be minimized for attaining an optimal capital structure. References Brigham, E. F., Ehrhardt, M. C. (2013).Financial management: Theory practice. Cengage Learning. Brigham, E. F., Houston, J. F. (2012).Fundamentals of financial management. Cengage Learning. Copeland, T. E., Weston, J. 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