What Is Optimal Capital Structure? – ValueWalk Premium

What Is Optimal Capital Structure?

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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.

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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