How do I calculate the optimal capital structure of a company?

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Expert Solution

Optimal Capital structure of a company is an appropriate mix of various sources of capital like debt, equity and retained earnings to maximize the value of the company by lowering it's cost of capital. Minimizing the Weighted Average Cost of Capital is a technique used to lower the cost of Capital. Formula of WACC is:

WACC= Ke(E/(D+E))+Kd(D/(D+E)

WACC is the Weighted Average Cost of Capital

Ke = Cost of Equity

E=Equity

D=Debt

Kd= Cost of debt is long term borrowing rate(1-tax rate)

Thus, having an appropriate weight of debt and equity will lower the overall cost of capital.

The Optimal capital strucuture can be achieved by including debt into it's capital structure. As issuing more of equity will lead to dilution which means shareholders will have less percentage of shares in hand. Including debt in the capital structure is a leverage as company will get tax benefit on debt as asource of capital. But, very high debt may also have probability of getting default which leads to liquidation of the company's assets to repay it's debt. Therefore, an appropriate mix of debt and equity is a must for optimal capital structure.

jeff jeffy answered 1 year ago

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