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Optimal Capital Structure

What is Optimal Capital Structure?

The best blend of capital sources for a company is a mixture of debt and equity financing. This combination minimizes the average cost of capital while making the company more valuable. Debt financing is more affordable because the interest paid on loans can be reduced from the company's taxable income, unlike the dividends paid to shareholders, which can't be reduced from taxes. However, it's not a good idea to rely too much on loans because having too much debt increases the risk of going bankrupt, which can damage the company's value. So, the ideal combination includes some low-cost loans and enough of the company's own money to reduce the risk of not being able to repay the loans. It's often tricky to pinpoint the exact right compound, so businesses usually aim for a range of values.

If a company's cash flow goes up and down a lot, it means it might have a hard time repaying loans. In such cases, the best capital structure would have very little debt and a lot of the company's money. On the other hand, if a company has stable and predictable cash flows, it can handle more debt, and the best capital structure would include a higher amount of loans.


Understanding Optimal Capital Structure

The perfect capital structure is crucial for a business to operate smoothly. It means finding a balance where the two main ways of financing—debt and equity—work well together.

In businesses, various factors impact a company's capital and cash flows. Where a company gets its money has a big effect on the company's value. It's often tempting for a company to borrow money to keep things running because it's one of the less expensive ways to get capital. That's because the cost of debt (the interest you pay on loans) can be subtracted from your taxes, and it's less risky.

But, if a company borrows too much, it raises the risk of going bankrupt and can make it harder to pay dividends. Even when the company isn't making a profit, it still has to make interest payments on its loans. This reduces the money available to pay dividends to shareholders. This situation increases the risk for shareholders, and they need to be rewarded for taking on that extra risk. So, the cost of getting more equity (selling shares) goes up, and it takes away the advantage of having cheap debt.

So, on one side, it's good for a company to use less expensive debt and reduce equity. But, on the other side, a company has to be careful not to get too deep into debt. To handle this, a company has to keep looking for affordable ways to get money and have a solid plan for its finances. This way, the company creates the best capital structure for itself