Question

5. Briefly explain what is meant by a firm’s optimal capital structure?

Answer 1

An optimal capital structure is the best proportion of equity and debt used in the capital of the firm. The capital structure should be such so that the weighted average cost of capital is minimum. The WACC or weighted average cost of capital is the mixture of Cost of equity and cost of debt. WACC should be kept as low as possible in order to maximise value.

1. Equity - A firm raises capital through issue of shares. Shares are issued to the public who pay the consideration in the form of cash.This is one of the major source of capital for a firm. In many instances the owners themselves provide the finances from their own to run the firm. Equity capital is genreally used for the long term objectives of the firm. However using equity capital results in dilution of ownership.
2. Debt - This capital is generally in the form of loans taken from financial institutions or through the issue of debentures. Here the firm has to repay the loans taken and to the debenture holders. Here the cost of capital is Interest. Banks while granting loans and advances charge certain interest on the borrowing which the borrower has to pay along with the principal amount. Most firms would look form debt financing for fulfilling both short term and long term objectives. However default in repayment of loans may also lead to serious financial implications for the firm.