Optimal Capital Structure
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.
As explained by Investopedia, the short 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.
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:
One method of estimating a company’s optimal capital structure is utilizing the average or median capital structure of the principle 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 principle company to be significantly different from the target capital structure.
Method 2This 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 a economically distressed company.