Optimal Capital Structure in Financial Management: Meaning, Example & Methods

Meaning and definition of Optimal Capital Structure

The optimal capital structure indicates the best debt-to-equity ratio for a firm that maximizes its value. Putting it simple, the optimal capital structure for a company is the one which proffers a balance between the idyllic debt-to-equity ranges thus minimizing the firm’s cost of capital. Theoretically, debt financing usually proffers the lowest cost of capital because of its tax deductibility. However, it is seldom the optimal structure for as debt increases, it increases the company’s risk. The short-term and long-term debt ratio of a company should also be considered while examining the capital structure. Capital structure is most commonly referred as a firm’s debt-to-equity ratio, which gives an insight into the level of risk of a company for the potential investors. Estimating an optimal capital is a key requirement of a company’s corporate finance department. A firm finances its activities using funds from debt and equity. Debt refers to loans the firm secures from outside sources. Equity refers money the firm's owners or stockholders invest in the firm.

 

A firm's capital structure is its ratio of long-term debt to equity. An optimal capital structure is the best debt-to-equity ratio for the firm, which minimizes the cost of financing and maximizes the value of the firm.

For Example - A firm's capital structure can be found mathematically by computing its minimum weighted average cost of capital. For example, if a company uses debt at 4 percent to get 30 percent of its funds and equity at 10.5 percent to get 70 percent of its funds, the firm's weighted average cost of capital is (0.30 X 4 percent) + (0.70 X 10.5 percent) = 8.55 percent. The formula implies that the firm can get a minimum weighted average cost of capital of 4 percent by using debt as its sole source of funds, but it would not be the firm's optimal capital structure because the firm would then face a high risk of bankruptcy.

Estimating the Optimal Capital Structure 

There are numerous ways in which a company’s optimal capital structure can be estimated. The most commonly used ones are:

1. Method 1 - One method of estimating a company’s optimal capital structure is utilizing the average or median capital structure of the principal companies engaged in the market approach. This approach is helpful as the appraiser is well aware about which companies are included in the analysis and the degree to which they are related to the subject company. However, this method features a limitation that fluctuations in market prices and the spread-out nature of debt offerings and retirements might cause the actual capital structure of a principal company to be significantly different from the target capital structure.
2. Method 2 - This method is applied if the risk of a company did not change because of the nature of its capital structure, and a company would wish as much debt as possible, as the interest payments are tax deductible and debt financing is always cheaper than equity financing. The main objective of this method is determining the debt level at which the benefits of increased debt does not overshadow the increased risks and potential costs associated with an economically distressed company.

Assumption of Optimal Capital Structure 

A "best" debt/equity ratio for a company this is the long-term-debt to equity ratio that will minimize the cost of capital, i.e., the cost of financing the company's operations. To develop a model that represents the current state of the art in the theory of optimal capital structure, we make the following assumptions.

1. Investors are risk-neutral.
2. Investors face a progressive tax rate on returns from bonds, tpb , while the firm faces a constant statutory marginal tax rate, tc.
3. Corporate and personal taxes are based on end-of-period wealth; consequently, debt payments (interest and principal) are fully deductible in calculating the firm's end-of-period tax bill, and are fully taxable at the level of the individual bondholder.
4. Equity returns (dividends and capital gains) are taxed at a constant rate, tps.
5. There exist non-debt tax shields, such as accelerated depreciation and investment tax credits, that reduce the firm's end-of-period tax liability.
6. Negative tax bills (unused tax credits) are not transferrable (saleable) either through time or across firms.
7. The firm will incur various costs associated with financial distress should it fail to meet, in full, the end-of-period payment promised to its bondholders.
8. The firm's end-of-period value before taxes and debt payments, X, is a random variable. If the firm fails to meet the debt obligation to its bondholders, Y, the costs associated with financial distress will reduce the value of the firm by a constant fraction k