How does capital structure typically affect the cost of capital?

The cost of capital is significantly influenced by a company's capital structure, which is the way a company finances its operations through a combination of debt and equity. When considering how different sources of funding affect the overall cost, it becomes clear that the structure impacts both debt and equity costs.

As a company increases its debt, the cost of debt may initially decrease due to the tax shield benefits associated with interest payments, which are tax-deductible. However, as more debt is added, it may lead to higher perceived risk of default among investors, resulting in higher interest rates. This dynamic showcases the interplay between debt levels and the cost of capital.

On the equity side, a higher level of debt can increase the financial risk for equity holders. As risk increases, investors may demand a higher return on equity to compensate for that risk, which in turn drives up the overall cost of capital.

Understanding this relationship demonstrates that capital structure does not merely segregate into short-term or long-term financing impacts but plays a crucial role in determining the costs associated with both debt and equity. This systematic relationship emphasizes the importance of capital structure decisions in corporate finance, guiding companies in their strategies to optimize financial performance.