CandleFocus Glossary Editor
Every company needs to accurately plan its financial strategy in order to maximize its potential for success. One of the most important components of financial strategy is obtaining the optimal capital structure. An optimal capital structure is the mix of debt and equity financing that provides the most value to a company’s investors while minimizing its cost of capital.
An optimal capital structure should be determined on an industry-by-industry basis as no one-size-fits-all approach exists. In general, a lower leverage ratio (ratio of debt to total assets) creates more equity in a company which in turn can increase its ability to borrow for larger investments. A higher leverage ratio, however, can allow a company to generate returns on its debt capital that exceeds its cost of capital, increasing its overall return on invested capital.
One way to determine an optimal capital structure is to minimize the company’s weighted average cost of capital (WACC). WACC is the weighted average of the cost of debt and equity capital multiplied by their respective proportions in the total capitalization of a company. While minimizing WACC maximizes the expected return of a given capital structure, the real challenge lies in finding the combination of debt and equity capital which creates the lowest WACC possible.
Businesses should consider several factors when creating their capital structure. For example, the tax advantages of debt financing can create the incentive to use additional debt to increase leverage, however, too much leverage can create risk if the company’s cash flows fail to provide sufficient returns.
Some economists argue that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, an efficient market should not be affected by a company’s capital structure due to market efficiency. In reality, however, these factors are rarely non-existent, making the optimal capital structure an important consideration for businesses, especially for those that wish to maximize the value of their returns to volatile capital markets.
In conclusion, an optimal capital structure is the combination of debt and equity financing that provides the most value to a company’s investors while minimizing its cost of capital. While minimizing WACC maximizes the expected return of a given capital structure, businesses need to consider numerous factors in order to create an appropriate combination for their particular circumstances.
An optimal capital structure should be determined on an industry-by-industry basis as no one-size-fits-all approach exists. In general, a lower leverage ratio (ratio of debt to total assets) creates more equity in a company which in turn can increase its ability to borrow for larger investments. A higher leverage ratio, however, can allow a company to generate returns on its debt capital that exceeds its cost of capital, increasing its overall return on invested capital.
One way to determine an optimal capital structure is to minimize the company’s weighted average cost of capital (WACC). WACC is the weighted average of the cost of debt and equity capital multiplied by their respective proportions in the total capitalization of a company. While minimizing WACC maximizes the expected return of a given capital structure, the real challenge lies in finding the combination of debt and equity capital which creates the lowest WACC possible.
Businesses should consider several factors when creating their capital structure. For example, the tax advantages of debt financing can create the incentive to use additional debt to increase leverage, however, too much leverage can create risk if the company’s cash flows fail to provide sufficient returns.
Some economists argue that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, an efficient market should not be affected by a company’s capital structure due to market efficiency. In reality, however, these factors are rarely non-existent, making the optimal capital structure an important consideration for businesses, especially for those that wish to maximize the value of their returns to volatile capital markets.
In conclusion, an optimal capital structure is the combination of debt and equity financing that provides the most value to a company’s investors while minimizing its cost of capital. While minimizing WACC maximizes the expected return of a given capital structure, businesses need to consider numerous factors in order to create an appropriate combination for their particular circumstances.