Optimal capital structure

The optimal capital structure of a business is that blend of debt and equity financing being used that minimizes its weighted-average cost of capital while at the same time 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.

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.

Related Courses

Corporate Finance 
Financial Analysis 
Treasurer's Guidebook