Question

The financial objective of every business is maximizing shareholder value and building a company that has value. To achieve that the company should strive to have the least weighted average cost of capital while maximizing profits.

How would this ideal situation serve as the basis for creating an Optimal Capital Structure for Higher option values?

Answer 1

Yes, the primary goal of business is, "Maximizing shareholder's value", by repurchasing the shares from market or by giving them higher dividends.

Company's primary motive is profit also, profit can only be higher when cost comes down. Cost of capital is one of them, cost of capital is the cost that incurs in raising the funds through shares or loan. If weighted average cost of capital comes down, company can increase its profit.

Optimal capital structure- It is the best capital structure that maximizes the profit for company and shareholders and minimizes cost of capital. It is an ideal mix of common shares, preferred shares and debt.

Debt financing provides lower cost of capital as the interest is deductible expenditure under tax but heavy debt is an obligation and burden for company. Lower cost of capital will increase the free cash flow to company. Companies should maintain an ideal debt to equity ratio for optimal capital structure.

For optimal capital structure, company should not finance 100% from equity or 100% from debt. Debt financing is good because interest is deducted for taxation purpose. Equity financing is costlier because of higher equity premium, cost of preferred stock is lesser as compare to equity as it attracts lower equity premium rates because the priority of paying dividend and capital. So company needs to have an ideal mix of all the three alternatives, company can also keep retained earnings, it can reinvest the retained earnings into the business.

If your company is already having lot of debt, it is not advisable to take more loan then you can go for equity financing. If rate of interest is lower in the country and you have no debt or very less debt in your capital structure then you can go for debt financing.

Conclusion- An optimal capital structure will decrease the WACC and lower WACC will increase cash flows and profitability for company.