Optimal Capital Structure

Reviewed by Athena | Updated on Aug 27, 2020

Introduction

The optimal capital structure of a company refers to the proportion in which it structures its equity and debt. It is designed to maintain the perfect balance between maximizing the wealth and worth of the company, and minimizing its cost of capital.

The objective of a company is to determine the lowest weighted average cost of capital (WACC), while deciding on its capital structure. The WACC is the weighted average of its cost of equity and debt. It is not mandatory for a company to take any debt. A company can have a capital structure that is all-equity, or a structure with minimal debt. It also depends on the industry the company belongs to, because standard capital structures vary from industry to industry, and whether the company is a private or public company.

Key Points in Designing an Optimal Capital Structure

1. Maximize the company's wealth An optimal capital structure will maximize the company’s net worth, wealth and market value. The wealth of the company is calculated in terms of the present value of future cash flows. This is discounted by the WACC.

2. Minimize cost of capital The lower the cost of capital, the lower the risk of insolvency. Companies in industries that have uncertain future cash flows should keep their cost of financing minimal. The lower the cost of capital, the higher will be its present value of future cash flows.

3. Simplicity in structure It should be simple to structure and understand. A complicated capital structure will only create confusion.

4. Maintain control An optimal capital structure maintains owners’ rights and control. It is also flexible and gives scope for future borrowing whenever necessary, without losing control.

How is the WACC calculated?

WACC =[D (Kd)/ (D+E)] +[D (Ke) x (1 - t)/ (D + E)]

D = Total debt

E = Total equity

Kd = Cost of debt

Ke = Cost of equity

t = Tax rate