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The Capital Structure of a firm is its mix of different securities issued by that firm. It looks at the combination of short and long-term debt securities, preferred stocks and equity that will be used to finance a firm’s assets. The optimal capital structure should strike a balance between risk and returns and thus maximize the price of a firm’s shares. This is because using more debt raises the risk borne by stockholders since more debt increases the riskiness of the firm’s earning stream which reduces share value. However, using more debt generally leads to a higher expected rate of return on equity. Higher risk tends to lower a stock’s price, but a higher expected rate of return raises it.
In choosing an ideal capital structure, financial managers are to consider the following factors:
Sales Stability
Asset Structure
The firm’s tax position
Financial flexibility
The relative percentages of debt and equity capital usually change as the company grows. In the long run, debt capital is less expensive than equity. Equity capital is normally the source used by very early-stage companies that do not have the cash flow to make debt payments. Investors who provide equity expect to receive a higher rate of return than lenders would. This higher return is their reward for taking the risk that the company will not succeed. As a company grows and becomes profitable, it can obtain more of its capital from debt sources. This allows the company's owners to hold onto their equity shares rather than having their ownership diluted by additional investors coming in.
Sources of debt capital, such as commercial banks, require that funds be repaid at a fixed schedule along with interest. Debt payments that are too high for the company's cash flow to support can cause a strain on the company's finances. In extreme cases, the company many not be able to fund important business functions that will help it grow, such as expenditures on new equipment to improve operating efficiency or marketing programs to increase revenues. Companies should have relatively stable cash flows before taking on debt and be able to make the required payments while still having a healthy cash balance in place.
Sufficient CapitalAll companies require capital to fund operations and expansion plans. Early stage companies often struggle with determining how much capital they need. Not having enough capital when you start a business makes it much more difficult to succeed. It usually takes longer to build a profitable company than entrepreneurs anticipate. Sufficient funding must be in place to keep the company going through the difficult start-up stage. Having too much capital at the outset can also cause problems. It may lead to wasting funds on unnecessary expenditures such as high priced office space. Entrepreneurs also must consider that equity capital comes with a price. You have to give up a piece of your company for the equity capital you receive. Bringing in more capital than you need means giving up a greater percentage of the company than you need to.
A company often acquires capital in stages throughout its life cycle. The company's initial capital structure can affect its ability to bring in the next stages of capitalization. Conflict can arise between the original shareholders and potential new investors over the issues of stock valuation and percentages of ownership. Existing shareholders may find their ownership percentage diluted when new investors are added. If management's share is diluted below50 percent, they can effectively lose control of the company to the investors. One of their goals of being in business for themselves -- autonomy -- won't be realized.
The best debt-to-equity ratio for a firm 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. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company's risk generally increases as debt increases.
The optimal mix is the mix which makes the lost cost of WACC without sacrificing and investment options that maximizes the shareholders wealth.
We can define as the optimal capital structure for a company it is the structure of capital which achieve maximizing company value and minimization cost of capital with relevant risk through the best mix between Debit and Equity.
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