Optimum Capital Structure¶
The optimum capital structure is the capital structure at which the weighted average cost of capital (WACC) is minimum, leading to the maximum value of the firm. In other words, it's the ideal mix of debt and equity that maximizes the value of a company.
Finding the optimum capital structure is crucial for a company because it directly impacts its cost of capital and, consequently, its overall financial performance. The goal is to strike a balance between debt and equity to minimize financing costs while maximizing returns to shareholders.
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If the return on investment is higher than the fixed cost of funds, the company should prefer to raise funds having a fixed cost, such as debentures, loans, and preference share capital. It will increase earnings per share and the market value of the firm. Thus, a company should make possible use of leverage.
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Debt is used as a source of finance. The firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in the computation of tax. Hence, the effective cost of debt is reduced, called tax leverage. A company should, therefore, take advantage of tax.
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The firm should avoid undue financial risk attached to the use of increased debt financing. If the shareholders perceive high risk in using further debt capital, it will reduce the market price of shares.
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Capital structure should be flexible.
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The firm should not depend on a single source of finance. It should use different sources of finance.
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