Question

what is optimal capital structure explain with graph

Answer 1

Solution.>

A firm's optimal capital structure is the best combination of debt and equity funding that maximizes the market value of a business while reducing its capital cost. In theory, debt financing owes its tax deductibility to the lowest cost of capital. Yet too much debt increases shareholders' financial risk and the return on equity they require. Basically optimal capital structure is that point where our cost of capital and risk of business will be minimal.

Let us look at the graph of optimal capital structure:-

When we calculate the weighted average cost of capital(WACC) with the help of the cost of capital, cost of debt and and debt equity ratio and draw it on the graph paper, we can reach optimal level of capital structure which is denoted by the Blue line in the graph. It is the point of (D/E)debt-equity ratio where is the WACC will be minimum as shown in the graph.

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