Question

How does one identify this optimum?

Should the capital structure change and what are the factors that will cause a firm to reevaluate its capital structure?

Answer 1

Answer:

• Capital Structure is optimum where there is :

1. Balance in tehe Equity capital and Debt capital of the entity ; and

2. Lower Weighted Average Cost of Capital and higher market exposure.; and

3. Which results in higher market value of the entity.

It denotes that after paying debt interest and all taxes earnings in hands of the equity share holders be more than the expected , which results higher market value of the share and higher market cap to the entity.

• Capital Structure can be change if required by firm. For example, If company needed funds for expansion of the business. Then firm has an option :

1. To borrow funds from banks, financial institutions ; or

2. Issue debt security and collect fund in such way that firm's interest cost burden be reduced.

• Following factors that will cause a firm to reevaluate its capital structure :

1. Need of funds : It depends on the firm that it needs short term funds for working capital or long term funds for expansion. It depends on the vision and plan of the firm.
2. Cost of Debt vs Caost of equity vs Cost of borrowing : Firm has to evaluate the cost of funds to be incurred in future in each case of debt, equity and loan. Where there is more benefit , according to that firm should choose option.
3. Tax benefits: Firm should eveluate the tax benefit and the effect of cash flow due to such benefit in every year of projection. It will get huge impact as if firm saves tax and use it to cope up the cost of capital. It reduces burden on the firm.
4. Present value of future cash flow and the Net present Value of the firm due to such capital structural change : Firm should evaluate the Present value of future cash flow and the Net present Value of the firm. If Net present value is positive only then firm can think about the change in capital structure. This is a good measure for change in capital structure for the firm.