Capital structure is referred to as the combination of owners funds (equity) and borrowed funds (debt) for financing its fund requirements. It can be calculated as debt/ equity ratio i.e. debt/ equity or as the proportion of debt in the total capital i.e.

‌

‌ Debt ‌

‌ Debt ‌+‌ Equity ‌

(i) Cost of Equity : Cost of equity means the expected rate of return on equity capital assuming risk. It is the rate of dividend on shares. When the company increase debt, the financial risk faced by equity holders also increases, as a result their rate of return may increase. Therefore company cannot uses debt beyond certain points, cost of equity may go up sharply and share price may decrease. Hence, for maximisation of shareholders wealth, debt can be used only up to a level.
(ii) Floatation cost : It refers to the cost of raising funds such as broker's commission and underwriting commission. The higher the floatation cost involved in raising funds from a particular source, the lower is its proportion in the capital structure. For instance, if public issue of shares involves higher floatation cost than debt, then the company would opt for more of debt and less of equity in the capital structure.