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An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital – or the rate it pays to use money – and maximize its market value.

In essence, an optimal capital structure attempts to optimize a firm’s cost of capital and the market value of its securities. There should be a judicious mix of short- and long-term debt to help create a lower overall cost of capital.

The cost of debt is lower than the cost of equity because interest on debt is tax-deductible. The cost of equity consists of the dividends a company pays to shareholders.

Debt-holders’ claims to funds take priority over shareholders. Debt may be cheaper, but it also carries the risk of not being able to make payments on time, which can lead to bankruptcy. The company must find an optimal capital structure that minimizes the cost of financing and minimizes the risk of bankruptcy.

If a company finances 40% of its efforts with debt at 5%, and the other 60% comes from equity at 10%, its average weighted cost of capital will be 8%.

While this suggests that a firm would incur a cost of capital of 5% if it used debt for all of its funding, that would not be its optimal capital structure because of the high bankruptcy risk it would carry. That risk grows as a company’s debt increases.

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