What Is Optimal Capital Structure?
Definition of Optimal Capital Structure
- The optimal capital structure of a firm is the right combination of equity and debt financing.
- It allows the firm to have a minimum cost of capital while having the maximum market value.
- The lesser the cost of capital, the more the market value of the company.
- Debt financing may have the lowest cost, but having too much of it would increase risks to the shareholders.
- So, firms need to find a balance between both to benefit from it entirely.
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What Impacts the Optimal Capital Structure?
- WACC
- Cost of debt
- Cost of equity
How to Calculate the Optimal Capital Structure?
- There is no specific formula to find the optimal capital structure, but what can be done is minimizing the WACC by listing out all the possibilities.
- Because it is tax-deductible, debt financing tends to have a lower cost than equity financing.
- However, it has to be kept in mind that having too much debt financing will affect the level of risk the company has.
Why is the Optimal Capital Structure Important?
- Firms that can manage to have an optimal capital structure would benefit from having more market value while having the minimum cost.
- Firms need to have it because no firms want to be paying too much money for less value.
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