Question

The flip side of capital budgeting relates to how the investments are financed. Discuss the concept of the capital structure, and more specifically, the concept of the “optimal” capital structure.

Answer 1

What is Capital Structure?

Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. The structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, and other investments. There are tradeoffs firms have to make when they decide whether to raise debt or equity and managers will balance the two try and find the optimal capital structure

Debt Assets Capital Structure Equity

Optimal capital structure

The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always used in practice, and firms often have a strategic or philosophical view of what the structure should be

Low leverage High leverage Debt $200 Debt $800 Assets $1,000 Assets $1,000 Equity $800 Equity $200

In order to optimize the structure, a firm will decide if it needs more debt or equity and can issue whichever it requires. The new capital that’s issued may be used to invest in new assets or may be used to repurchase debt/equity that’s currently outstanding as a form or recapitalization.