Question

Define the capital structure puzzle and highlight if there is an optimal capital structure. How do organizations determine their optimal capital structure?

Answer 1

The capital structure puzzle refers to finding the optimum capital structure based on different costs of capital components.

Every business organization has different costs of debt and equity depending upon its profitability, creditworthiness and investor expectations from the business. Due to this there is no single optimum capital structure. The capital structure comprises of a mix of debt and equity. Higher debt reduces the cost of capital due to tax advantages on interest payments. However it also increases the risk of the organization and hence the company should be able to strike the right balance between debt and equity.

The optimal capital structure for an organization is that mix at which its weighted average cost of capital is the least. Weighted average cost of capital is computed as the sum of Weights* cost of the individual capital components. This will ensure that the value of the organization is highest at the optimal capital structure.