Financial management and capital structure

Financial management decides three things: where to invest (investment decision), how to finance it (financing decision) and how much profit to return to owners (dividend decision) — with the goal of maximising owners' wealth, usually read as maximising the firm's market value. Capital structure is the mix of debt and equity that funds the firm. Worked example: a firm funded 60% by equity costing 14% and 40% by debt costing 8% before tax, with a 25% tax rate, has an after-tax debt cost of 6% and a weighted average cost of capital (WACC) of 0.6 x 14% + 0.4 x 6% = 10.8% — the hurdle rate its new projects must beat. Debt is cheaper than equity because lenders take less risk and interest is tax-deductible, but too much debt raises bankruptcy risk, which is why the optimal structure balances the two.