Optimum capital structure refers to the best mix of debt and equity financing that maximizes a companys market value while minimizing its cost of capital. The goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest weighted average cost of capital (WACC) and the maximum value of the company (shareholder wealth) . The lower the cost of capital, the greater the present value of the firms future cash flows, discounted by the WACC.
The key features of optimum capital structure are its simplicity and ability to ensure maximum profitability by minimizing the cost of capital. It works on the aspects of control, conservatism, flexibility, and a regulated debt-equity mix. The optimum capital structure plays a crucial role in financial management, allowing a firm to raise the necessary funds from different sources at the least cost.
Determinants of optimum capital structure include maximizing the companys wealth, minimizing the cost of capital, simplicity in structure, and maintaining control. The theories of capital structure include the M + M (No Tax), M + M (With Tax), Traditional Theory, and the Pecking Order. The trade-off theory of capital structure tells us that managers should seek an optimal mix of equity and debt that minimizes the firms WACC, which in turn maximizes company value.
In summary, the optimum capital structure is the best mix of debt and equity financing that maximizes a companys market value while minimizing its cost of capital. It is crucial for financial management and involves a trade-off between the benefits of higher leverage and the costs of financial distress. The goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company.
