Optimal capital structure definition

What is Optimal Capital Structure?

The optimal capital structure of a business is the blend of debt financing and equity financing that minimizes its weighted-average cost of capital while maximizing its market value. Debt financing is less expensive than equity financing, since the interest expense associated with debt is tax deductible, while dividend payouts are not tax deductible. This cost differential does not imply that the optimal capital structure should be comprised entirely of debt, since an excessive amount of debt increases the risk of bankruptcy, which lowers the market value of a business. Instead, the optimal structure involves a blend of lower-cost debt and a sufficient amount of higher-cost equity funding to mitigate the risk of being unable to pay back the debt. It may be difficult to find the exact point of optimization, so managers usually attempt to operate within a range of values.

If a business has highly variable cash flows, then it is less able to pay back any debt outstanding. In this situation, the optimal capital structure is likely to contain very little debt and a large amount of equity. Conversely, if a business has steady and consistent cash flows, then it can tolerate a much larger debt load; the resulting optimal capital structure contains a much higher percentage of debt.

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How Optimal Capital Structure is Measured

The capital structure is commonly measured with the debt-to-equity ratio. The ratio is usually plotted on a trend line to see how it is changing over time. It may also be compared to the same ratio for other businesses within the same industry, to see if company management is employing an unusual amount of debt within its capital structure. Management may also receive signals from the investment community regarding the perception of its capital structure in the marketplace; this may be in the form of increasing interest rates on new debt when investors think that the capital structure is becoming too unbalanced in favor of debt.

Problems with Optimal Capital Structure

It is not possible to mathematically derive the perfect optimal capital structure. This is because there are so many variables involved, including the following items:

  • The industry in which a company is located. When an industry is highly competitive, it is more difficult to maintain a high debt level, since the business might not be able to pay off the debt.

  • Where it is positioned on its growth curve. A rapidly-growing company may require an unusually large proportion of equity, since it is generating too little cash flow to even pay the interest on a large debt load.

  • Changes in the regulatory environment. In a business with tight government oversight, it is possible that the government will mandate a conservative capital structure, in order to reassure customers. This is common in the banking industry.

  • Changes in the market rate of interest. When the interest rate increases, it is harder to make ongoing debt payments - which tends to call for a higher proportion of equity capital.

Furthermore, the optimal capital structure is constantly changing, as all of the preceding factors interact over time. Realistically, a business can only hope to maintain an approximately optimal capital structure.