The decision to make an investment is based on this benchmark. Mostly the companies employ various sources of finance such as equity, preference, debentures, term loans etc. The calculation of WACC is done using the weights of the different components of capital base.
There are varying returns for all the sources. As the equity holders bear the maximum risk, the returns required by them is higher than the other investors. This is mainly because in case of extreme situation like insolvency, the equity shareholders have the last claim on the assets of the company. In such situations preference is given to the lenders of the company. Moreover, the declaration of dividends is not mandatory for the companies. A dividend is declared only if the company has surplus earnings whereas the payment of interest cost is mandatory. The company has to honour its debts irrespective of its profitability. This is the reason that the lenders get a lower return as compared to equity holders. But, if the company is highly leveraged, even the lenders become cautious and demand for higher returns. This is the reason that all the companies try to optimize their capital base for minimizing the cost of capital.
The cost of capital is the minimum return that a company must earn from the business activities to payoff its investors who provide the necessary capital in the form of shares, debentures and loans. Two sets of information are needed for calculating the cost of capital- weights of the various sources of finance and their respective costs.
Many studies have been conducted on the cost of capital which is dependent on the composition of the capital base of the company. The capital structure of a business measures the ability of a company towards meeting the needs of its stakeholders. Modigliani and Miller (1994) highlighted how the value of the firm is not affected by its capital structure as the tax advantage of debt