Optimal Capital Structure

Loading the player...

What is an 'Optimal Capital Structure'

An optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for a company is one that offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility; however, it is rarely the optimal structure since a company's risk generally increases as debt increases.

BREAKING DOWN 'Optimal Capital Structure'

A company's ratio of short- and long-term debt should also be considered when examining its capital structure. Capital structure is most often referred to as a firm's debt-to-equity ratio, which provides insight into how risky a company is for potential investors. Determining an optimal capital structure is a chief requirement of any firm's corporate finance department.

Companies can raise capital with either debt or equity. Each strategy has its own advantages and disadvantages. Debt usually costs less than equity due to tax advantages, especially when rates are low. However, debt also obligates the company to pay out a portion of future earnings, even when earnings are declining. By contrast, equity does not need to be paid back; however, equity comes with an exchange of ownership. Most companies use a mix of both debt and equity to raise capital. This mix is referred to as the capital structure. It is the goal of most public companies to operate at an optimal capital structure to maximize profits.

Optimal Capital Structure

There are two ways to think about optimal capital structure. One is personal and one is business-related. A chief executive officer (CEO) may not like debt in her personal life; however, her company may require the use of debt to maximize profits. At some point the debt becomes a strain on earnings. Qualitatively, the optimal capital structure lies somewhere between maximum profitability and financial burden.

Quantifying Optimal Capital Structure

The most popular way analysts measure capital structure is with the debt-to-equity ratio. Some analysts compare it against other companies in the same industry. The assumption is these companies are operating at an optimal capital structure, which is a significant assumption. In this case, an analyst can select a few of the best-performing or high-growth companies in the industry for comparison. The assumption holds but is less significant.

Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the company into a credit profile using a bond rating. The default spread attached to the bond rating can then be used for the spread above the risk-free rate of a AAA-rated company.

RELATED TERMS
  1. Traditional Theory Of Capital Structure

    The theory that when the Weighted Average Cost of Capital (WACC) ...
  2. Capitalization Structure

    The proportion of debt and equity in the capital configuration ...
  3. Long-Term Debt To Capitalization ...

    A ratio showing the financial leverage of a firm, calculated ...
  4. Capitalization Ratios

    Indicators that measure the proportion of debt in a company’s ...
  5. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
  6. Recapitalization

    Restructuring a company's debt and equity mixture, most often ...
Related Articles
  1. Markets

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  2. Investing

    Capital Structure

    Capital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
  3. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  4. Investing

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  5. Markets

    Debt Reckoning

    Learn about debt ratios and how to use them to assess a company's financial health. You could save a lot of money!
  6. Investing

    Financial Leverage In Corporate Capital Structure

    Corporate management uses financial leverage to increase earnings per share and return-on-equity.
  7. Investing

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  8. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  9. Markets

    Yahoo Stock: Capital Structure Analysis (YHOO)

    Learn about Yahoo's capital structure, including whether or not a decline in year-over-year earnings is leading the company to use more debt.
  10. Markets

    UPS Stock: Capital Structure Analysis

    Analyze UPS' capital structure to determine the relative importance of debt and equity financing. Identify the factors influencing financial leverage trends.
RELATED FAQS
  1. How do bankruptcy costs affect a company's capital structure?

    Understand the Modigliani and Miller theory of capital structure. Learn how the theory shows how bankruptcy costs affect ... Read Answer >>
  2. Which financial ratio best reflects capital structure?

    Learn about the debt-to-equity ratio and why this metric is widely considered the most useful reflection of a company's capital ... Read Answer >>
  3. How do interest rates influence a corporation's capital structure?

    Learn about how changing interest rates can affect a corporation's capital structure because of their impact on the cost ... Read Answer >>
  4. What is considered a high debt-to-equity ratio and what does it say about the company? ...

    Learn how to make sense of the debt-to-equity numbers of a company when looking for good investment opportunities. Read Answer >>
  5. Which is more important when estimating cost of capital - debt or equity?

    Learn about the relative costs of debt and equity and how they affect the overall cost of capital, including why debt may ... Read Answer >>
  6. How can I use the debt-to-capital ratio to evaluate a stock?

    Understand the significance of the debt to capital ratio of financial leverage, and learn how investors and analysts make ... Read Answer >>
Hot Definitions
  1. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  2. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  3. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  4. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  5. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  6. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
Trading Center