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Optimal Capital StructurePresented by:Ramesh PantBBM-18Fourth SemesterFinancial ManagementThe Optimal Capital StructureMaximizes shareholder wealthMaximizes firm valueMaximizes stock priceMinimizes WACCDoes NOT maximize EPS

Optimal Capital Structure - that mix of debt and equity which maximizes the value of the firm or minimizes the cost of capitalEstimating the Optimal Capital Structure: 5 StepsEstimate the interest rate the firm will pay (cost of debt)Estimate the cost of equityEstimate the WACCEstimate the free cash flows and their present value (value of the firm)Deduct the value of debt to find Shareholder Wealth Maximize

Optimal Capital StructureAn optimal capital structure is the optimal ratio of debt and equity that is used to finance a company's assets.

Conventionally, the ratio is said to be optimal when itminimizes the company's Cost of Capital, which is defined as a sum of the costs of debt and equity for the company weighted to their respective debt/equity proportions used by the company.Thecost of debtdepends on factors like market interest rates, default risk of the company, existing debt levels, as well as the marginal tax rate applicable.

Thecost of equitydepends on factors like market interest rates, average returns of the market/industry, and volatility of the company's stock.There is alsosubstantial interplay between the two costs. For instance, higher debt levels will increase cost of equity as equity investors will view a debt laden firm as riskier. At the same time, this might be offset from a greater tax advantage enjoyed due to higher debt levels (interest payments are tax-deductible while dividends are not).

Thus, optimal capital structure is theright amount of debt and equity that, taking into account all the factors above, minimizes the company's cost of capital.Note that this concept of an optimal capital structure islargely theoretical.In the real world, there are other factors affecting capital financing that are not captured in such theoretical models.For instance, a company with volatile revenues might want to keep low debt levels since interest payments are fixed, regardless of the company's performance, while dividends are flexible.For another, low debt levels mean high credit ratings, which have a managerial ego factor associated with them. Whether this is in the best interests of shareholders is another matter.In conclusion, optimal capital structure serves as a good long-term indicator of where a firm might be headed with its debt/equity mix, but in the short run, you'll often find companies different from the optimal for genuine, reasonable reasons.