State about the capital structure of financial risk

Frequently the funds supplied to a firm by lenders will change its financial structure and charge for the funds would be based on the changed financial structure. In analysis of the cost, however, firm's financial structure is presumed to remain fixed. This supposition is essential in order to isolate the costs of the different forms of financing. If firm's capital structure were not held constant, it would be quite difficult to find its cost of capital, because the selection of a given source of financing would change the costs of alternate sources of financing.

Assumption of a constant capital structure implies that when a firm raises funds to finance a given project these funds are raised in same proportions as firm's existing financing. Awkwardness of this assumption is obvious as in reality a firm raises funds in 'lumps,' it doesn't raise a mixture of small amounts of various types of funds. For instance, in order to raise USD. l million a firm may sell either bonds, common stock or preferred stock in the amount of USD. l million; or it may sell USD. 400,000 worth of bonds, USD. 100,000 worth of preferred stock and USD. 500,000 worth of common stock. Most firms would use the former strategy though our analysis of cost of capital is based on the assumption that firm will follow latter strategy. More sophisticated approaches for measuring the cost of capital when a firm's capital structure is changing rare available.