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What Diagramming Teaches Us
When Joseph R. Mallon Jr. bumps up against a complex problem, he thinks back to a lesson he learned in high school from the Sisters of the Immaculate Conception.
The Philadelphia-area school's Catholic nuns taught him the art of diagramming a sentence. Once all the parts of speech lined up, Mallon pulled clarity from the chaos. It's a process he uses today to tackle tough issues as chief executive and chairman of Measurement Specialties Inc.
"Sit down quietly. Take (the issue) apart into its component parts. Make sure all the components fit together well. They've got to be well chosen, fit together and make sense. There are few (business) problems that can't be solved that way, as dire as it might seem," Mallon said. "Sentence diagramming is one of the best analytical techniques I ever learned."
Investor's Business Daily
17 October 2000
Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.
A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.
Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure represents how a firm finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.
A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.
Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt increases. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness. We'll discuss optimal capital structure further in section 14.
Controllable Factors Affecting Cost of Capital
These are the factors affecting cost of capital that the company has control over: