optimal capital structure

Examples of optimal capital structure in the following topics:

• Optimal Capital Structure Considerations

  • The optimal capital structure is the mix of debt and equity that maximizes a firm's return on capital, thereby maximizing its value.
  • In short, capital structure can be termed a summary of a firm's liabilities by categorization of asset sources.
  • One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital.
  • Management must identify the "optimal mix" of financing, which is the capital structure where the cost of capital is minimized so that the firm's value can be maximized.
  • Explain the influence of a company's cost of capital on its capital structure and therefore its value

• Leverage Models

  • The first and most famous, the Modigliani–Miller theorem, forms the basis for modern thinking on capital structure.
  • The Modigliani–Miller theorem is also often called the Capital Structure Irrelevance Principle.
  • Although the conditions of the theorem are never met in a real market scenario, the theorem is still taught and studied because it tells something very important - capital structure matters precisely because one or more of these assumptions is violated.
  • It tells us where to look in order to determine, and how those factors might affect, the optimal capital structure.
  • In other words, as the level of leverage increases by replacing equity with cheap debt, the WACC drops and an optimal capital structure does indeed exist.

• Funding the International Business

  • There are two ways in which the capital can end up at the borrower: (1) The lender can lend the capital to a financial intermediary, against interest.
  • A international business chooses sources of funding based on its capital structure to find the best debt-to-equity ratio that maximizes its value.
  • The optimal capital structure for a company is one which offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital.
  • However, it is rarely the optimal structure since a company's risk generally increases as debt increases.
  • These are an important source of capital for multinational companies and foreign governments.

• Tax Considerations

  • Tax considerations have a major effect on the way a company determines its capital structure and deals with its costs of capital .
  • This leads to a conclusion that capital structure should not affect value.
  • The optimal structure then, would be to have virtually no equity at all.
  • However, we see that in real world markets capital structure does affect firm value.
  • Therefore, we see that imperfections exist; often a firm's optimal structure does not involve having one hundred percent leveraging and no equity whatsoever.

• Cost of Capital Considerations

  • Cost of capital is important in deciding how a company will structure its capital so to receive the highest possible return on investment.
  • One of the major considerations that overseers of firms must take into account when planning out capital structure is the cost of capital.
  • By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock).
  • Management must identify the "optimal mix" of financing–the capital structure where the cost of capital is minimized so that the firm's value can be maximized.
  • Describe the influence of a company's cost of capital on its capital structure and investment decisions

• Capital Structure Overview and Theory

  • A firm's capital structure is the composition or 'structure' of its liabilities.
  • In reality, capital structure may be highly complex and include dozens of sources.
  • Modigliani and Miller created a theory of Capital Structure in a perfect market.
  • The value of a company is independent of its capital structure
  • The optimal structure, then would be to have virtually no equity at all.

• Trade-Off Consideration

  • The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.
  • It is often set up as a competitor theory to the pecking order theory of capital structure.
  • Therefore, a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
  • Therefore, trade off considerations change from firm to firm as they impact capital structure.
  • Trade-off considerations are important factors in deciding appropriate capital structure for a firm since they weigh the cost and benefits of extra capital through debt vs. equity.

• Long-Term Approach

  • Recognize the broader objectives of working capital, as well as how organizations can consider a long-term perspective when viewing the utilization of working capital.
  • This free working capital can be utilized in a variety of ways.
  • Working capital under-utilized incurs the opportunity costs associated with the time value of money, and organizations must use financial planning to ensure appropriate utilization of this capital over the longer term.
  • From a longer-term perspective, working capital profitability decisions revolve around how much should be available within any short-term time frame in order to maximize the return (on average) of existing working capital.
  • By looking at differences in working capital availability over a long period of historical data, the organization can make rough estimations of the optimal amount of working capital availability that allows optimal growth.

• The Marginal Cost of Capital

  • The marginal cost of capital is the cost needed to raise the last dollar of capital, and usually this amount increases with total capital.
  • Generally we see that as more capital is raised, the marginal cost of capital rises .
  • Usually, we see that in raising extra capital, firms will try to stick to desired capital structure.
  • The Marginal Cost of Capital is the cost of the last dollar of capital raised.
  • Describe how the cost of capital influences a company's capital budget

• The Cost of New Common Stock

  • Issuing new common stock is a time intensive process that gives access to capital with various direct and indirect costs.
  • When it comes to the cost of capital, common stock is one of a few options on the table for raising funding.
  • From various debt instruments to preferred stock to common stock, larger organizations tend to diversify funding input to optimize their potential financial leverage.
  • In terms of literal capital spent, the issuance of new common stock incurs a variety of capital costs both at the initial offering and throughout the process of managing this funding source over time:
  • Weigh the direct and indirect costs of issuing new common stock as a form of capital