Optimal Capital Structure

Optimal Capital Structure

Introduction

The study is related to the optimal capital structure and the factors that influence in the choice of optimal capital structure. The optimal capital structure is the mix of financing that minimizes the cost of capital and thereby maximizes the value of the entity by using the capital to carry out the business activities. The study particularly focuses on the concept of business disruption costs as well as it enlightens the idea of tax-deductible interest. Moreover, the study also explains the agency costs of debt and equity based on the theoretical evidences.

Discussion

Optimization of capital structure is one of the most difficult problems to be solved in the management of corporate finance. The optimal capital structure is a ratio of debt to equity, which provides the most effective relationship between the coefficients of return on equity and debt, that is, maximizes the market value of the corporation. The process of optimizing the capital structure include the analysis of the composition of capital in the time series of periods (quarters, years) as well as trends in its structure. During the analysis considers parameters such as coefficients of financial independence, the debt ratio between long-and short-term obligations. Moreover, it is also important to study the rates of turnover and return on assets and equity to assess the major determinants of capital structure. They are:

industry characteristics and economic activity;

stage of the life cycle of the firm;

conjuncture of commodity and financial markets;

profitability of current operations;

tax burden on the company (share paid by direct and indirect taxes in revenue from sales);

degree of concentration of share capital.

A starting point of the theoretical investigation in optimal capital structure is the irrelevance theorem by Modigliani and Miller (1958). It argues that as long as firms maximize just their value, the capital structure is irrelevant to their optimization problem. Because this theorem assumes that there are no frictions such as taxes, bankruptcy costs, agency costs, and asymmetric information, subsequent papers have tried to find out which frictions make corporate capital structure relevant to firms and investigate their implications.

Business Disruption Costs and Tax-Deductible Interest

The optimal capital structure that maximizes the value of the company is also one that minimizes the cost of capital. It is defined as the specific combination of long-term debt and equity of the company to fund operations and / or the company's own investments. This structure implies an Inter-off between risk and performance, as using a larger amount of debt increases the risk of the profits of the company and if the debt is higher, it leads to a higher rate of return.

In addition to this, the debt financed is valuable in the optimal capital structure because of the interest tax deductibility in debt. However, increase in the debt structure can increase the probability of bankruptcy costs which can affect the firm (Baker and Wurgler, 2002, 1-32). The theory of capital structure does not give a complete answer to the question of the optimal capital structure. It can only realize the many benefits of ...