Optimal Capital Structure

The optimal capital structure of a company is the best mix of debt and equity financing that minimizes the company’s overall cost of capital while maximizing the value of the firm. It represents a balance between the benefits of debt financing and the risks associated with excessive borrowing. Key Features Components of Capital Structure Debt Financing: Borrowed funds such as loans or bonds. Advantage: Interest payments are tax-deductible, reducing the effective cost of capital. Risk: Excessive debt increases the likelihood of financial distress or bankruptcy. Equity Financing: Funds raised from shareholders. Advantage: No mandatory repayments; less risk of insolvency. Disadvantage: Dividends are not tax-deductible and equity is generally a more expensive source of capital. Objective Minimize the Weighted Average Cost of Capital (WACC) Maximize shareholder wealth Maintain sufficient liquidity and financial flexibility Trade-Off Principle Using more debt can lower capital cost due to tax benefits but raises financial risk. Using more equity reduces risk but increases the overall cost of capital. The optimal structure achieves the best balance between cost efficiency and risk management. Determination There is no fixed ratio; companies usually aim for a range of debt-to-equity ratios based on: Industry norms Cash flow stability Market conditions Risk appetite Example A company considers three financing options: Option Debt Equity WACC Risk 1 80% 20% Low High (default risk) 2 50% 50% Minimum Moderate 3 20% 80% Higher Low risk Optimal choice: Option 2 — balances cost efficiency and financial stability.