Question

Describe what it means to have an optimal capital structure? What balance is needed and how can this theoretically be achieved?

Answer 1

The capital structure of a firm is based on the arrangement of different sources of funds which are used to finance the operations of the firm. It is generally consists of debt, preferred stock and common equity. It is important because an optimal capital structure has least weighted average cost of capital (WACC) and it is good for overall business of the firm.

The effective cost of capital for a company is its weighted average cost of capital (WACC). It is the cost of raising capital, where the weights represent the proportion of each source of financing that is used in capital structure of the company. Companies should choose the capital structure which can give it the lowest effective cost of raising the fund. It is used as a discount rate in net present value calculation. The company’s cost of capital depends on its riskiness. The expectation of changing costs of capital can be incorporated into the capital budgeting decisions by its weighted average cost of capital (WACC).