The optimal capital structure of a company is the mix of equity and debt it uses to finance its operations. This structure aims to strike the right balance between increasing the company's value and keeping its cost of capital low.
A company's goal is to find the lowest weighted average cost of capital (WACC) when setting up its capital structure. The WACC combines the cost of equity and debt. However, a company isn't required to take on any debt and can choose a capital structure made up entirely of equity or one with minimal debt. The ideal capital structure can vary depending on the industry and whether the company is private or public, as different industries have different standards. In this article, you will learn more about optimal capital structure for CA Exams .Also Check: Difference Between Accounting and Economic Profit
Maximize the Company's Wealth
An optimal capital structure should enhance the company's net worth, wealth, and market value. This is achieved by maximizing the present value of future cash flows, which are discounted by the weighted average cost of capital (WACC).Minimize the Cost of Capital
Keeping the cost of capital low reduces the risk of insolvency, especially for companies in industries with unpredictable cash flows. A lower cost of capital increases the present value of future cash flows, contributing to the company's overall value.Simplicity in Structure
The capital structure should be straightforward and easy to understand. A simple structure avoids confusion and ensures that all stakeholders clearly grasp the financial strategy.Maintain Control
The optimal capital structure preserves the owners' control rights while remaining flexible enough to allow for future borrowing if needed. This flexibility ensures that the company can raise funds without diluting ownership or losing control.