Question

Define the capital structure (leverage) of a firm. What do you consider to be the optimal capital structure for a firm?

(Hint: be sure to include different types of financing options a firm uses)

Answer 1

The capital structure of a company refers to the portion of debt and equity in the company, and the types of debt and equity used to fund the operations of the company

Value of the firm is decided based on the appropriate capital structure of the company. Cost of equity is usually higher than cost of debt (generally). Hence, use of debt decreases the cost of capital (WACC = % of equity * cost of equity + % of debt * cost of equity). Having said this, however, one cannot increase the debt to very significant level as that would increase the cost of debt as risk increases and hence, defeat the purpose.

So the optimal level of debt is needed to determine the optimal capital structure

Sources of different types of financing options a firm uses:

Major Categories are:

1. Debt (short term and long term)

2. Equity

3. Preference Shares