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Optimum Capital Structure: Meaning And Features

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Capital Structure Meaning

The capital structure of a corporation is the method of financing its assets and activities via a combination of debt and equity.

A company’s optimum capital structure is the combination of debt and equity financing, which optimizes market value while reducing the cost of capital. Since interest payments on debt are often tax-deductible, they provide a very cheap source of money.

Moreover, excessive debt raises the necessary return on equity for shareholders and the associated financial risk. Therefore, businesses must determine their optimum level of debt, where the marginal gain is equivalent to the marginal expense.

Now after checking out the definition of Capital Structure, let’s analyze the optimal capital structure and its utility.

Recognizing Value Of Optimal Capital Structure

To estimate the optimal capital structure, one must determine the proportions of debt and equity, maximizing the firm’s market value while minimizing the WACC. The present value of the company’s future cash flows, discounted by the WACC, is larger if the cost of capital is less.

The primary objective of every corporate finance division is to find the appropriate capital structure that yields the lowest WACC and provides the greatest value to the firm.

Capital Structure and WACC Optimization

Since debt is seen to have less degree of risk than equity, its cost is lower. As interest costs take precedence over dividends and debtors have priority in the case of a dissolution, the yield needed to repay debt investors is smaller than the return required to satisfy stockholders.

Too much debt, however, may raise interest payments, earnings instability, and the likelihood of bankruptcy. Therefore, it’s important to strike a balance. The WACC rises, and the market value of a company falls because investors want a higher return to offset the increasing financial risk they face.

A firm with very unpredictable cash flows would have a relatively small debt and a significant equity stake.

Features of Optimal Capital Structure

In addition to the rights of different kinds of securities on Income, claim on Property, and the power to exercise control, the additional features or traits of an ideal or optimal capital structure are worth considering:

Efficiency 

Simplifying the process of obtaining capital implies issuing stock and preference shares at the beginning and, after that, issuing debentures.

As a result, diversification risks should be phased in over time as the company expands. It will boost investors’ confidence, making it simpler to get financing.

Reducing Exposure to Danger

Every company faces a unique set of challenges, including but not limited to the following:

  • Market competition
  • Shifts in product demand
  • Fluctuations in supply and demand
  • Alterations in the climate
  • Increases in taxation, interest rates, inflation, and other government policies
  • Declines in consumer buying power
  • Increases in operating expenses

These dangers impact both planning and the formation of a sound financial foundation. That’s why the capital structure must be adjusted so that the company can effectively bear the brunt of these dangers when necessary.

Sufficient Cash on Hand 

A bank needs to have a capital structure and asset allocation that allows it to have sufficient cash in hand at all times. For this reason, the corporation may sell debentures that can be resold or repurchased on the marketplace.

Overview: Capital Structure Theories

The M&M Theorem (Theory of Modigliani and Miller)

Franco Modigliani and Merton Miller’s namesake theory on capital structures is known as the Modigliani-Miller theorem (M&M for short). It was in 1958 when two economics experts, Modigliani and Miller, who had been working on a theory of capital structures, came up with the capital structure irrelevance statement. According to this theory, a firm’s market value in ideal markets is independent of its capital structure since it is based on its underlying assets’ earnings potential and risk. The M&M theorem proposed the two statements below:   Proposition 1 According to this theory, how a company’s finances are set up doesn’t affect its worth. If two companies were the same in every way except the method through which they financed their assets, then their market worth would be the same regardless of which method was used. Proposition 2 This hypothesis states that using financial leverage increases a company’s value and decreases its WACC. It’s the time of year when tax data may be accessed. 

The Concept of Pecking Order

Asymmetric information costs are central to the pecking order hypothesis. The method is focused on the premise that businesses would choose the easiest option when allocating their capital. The use of internal financing is strongly favored over the use of debt or external equity financing, both of which should be considered as the last venue.

Relevance Of Capital Structure In Financial Management

The company’s capital structure is how it finances its assets and operations through equity and debt. If a company is looking for a more permanent funding source with more cash flows, it should choose stock, which is more costly but more stable. Merger and acquisition (M&A) activities, which may be funded by cash, borrowing, share assumption, and/or debt assumption, in addition to revenues from divestitures and sale of assets, may have a substantial impact on capital structure in addition to stock and debt issuance.

 Capital Structures: Types

Equity and debt are the two main categories of long-term financing, and capital structure refers to the way they are allocated over time. Preference shares, equity capital, retained profits, long-term loans, etc., are all examples of how a company might get funding. The company has to obtain these sums to keep operations afloat. Let’s check out in detail about them:  Equity Capital Investors’ or owners’ equity is the same thing as equity capital. Two distinct varieties are included. Retained earnings:  It is the portion of profits set aside by the company to be used for future investments in its growth and development. Contributed Capital:  The total sum of money that the firm’s founders or first investors put into the business in exchange for a stake in the firm. Debt Financing:  Debt capital refers to the sums of money borrowed and invested in a company. Several types of debt financing exist. Long-term bonds are the most secure kind of debt since their principal is not due until maturity, but interest payments may be deferred indefinitely. Businesses may often issue short-term debt instruments like commercial paper to obtain funds for a limited time. Capital Structure Optimization:  The term “optimal capital structure” describes the optimal allocation of a firm’s financing between debt and equity. A high debt ratio is not desirable for a corporation in the mining or oilfield and oil extracting industries; however, it is common in the banking and insurance sectors. Leverage in Finance The level of financial leverage is measured by how much debt is used as a percentage of total investment. Capital gearing is another name for this concept. A highly leveraged business has a high debt-to-equity ratio, whereas a low-levered company has a low debt-to-equity ratio.

Conclusion

Reaching and maintaining the optimum capital structure should be a goal of every successful business. For maximizing the market price of the shares, the best capital structure has about the lowest average cost of capital possible, given a certain level of revenue.

Reference

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