Question

As financial analyst, your intriguing sense wanted to identify the optimum Capital Structure enabling you to offer options to your CEO and the Management. As an analyst you decided to identify the optimal Capital Structure for the company and give your reasoning on the same

Answer 1

The optimal capital structure for different company can be different, even within an industry different companies will have different level of capital structure and the cost to them would be different. The reason behind this is that for companies their ability to raise capital through debt and equity are different and it depends on their credit rating and how the investors see them in the market. Different firms can raise debt at different cost. The firm capital structure should be in a ratio where the weighted average cost of capital is least and the firm value can be maximized. As more debt is added to the capital structure the company becomes more leveraged and as the company becomes risky, and also as the level of debt increases the cost of equity also increases and the probability of default increases so the company debt to equity should be in such a way that the weighted cost is least, distress cost is low and the value of firm can be maximized.