Optimum Capital Structure

Recently updated on April 13th, 2023 at 06:41 pm

An optimum capital structure has such a proportion of debt and equity which will maximise the wealth of the firm. At this capital structure the market price per share is maximum and cost of capital is minimum.

Brigham defines: “The optimum capital structure strikes that balance between risk and return which maximises the price of the stock and simultaneously minimizes the firm’s overall cost of capital.” Generally speaking, a sound optimum capital structure is one which:

(i) Maximises the worth or value of the firm

(ii) Minimizes the cost of capital

(iii) Maximises the benefit to the shareholders by giving best earning per share and maximum market price of the shares in the long-run

(iv) Is fair to employees, creditors and others.

Features of an Optimum Capital Structure:

Simplicity:

All businessmen are not educated. A complicated capital structure may not be understood by all; on the contrary it may raise suspicions and create confusion. A capital structure must be as simple as possible.

Profitability:

An optimum capital structure is one which maximises earning per equity share and minimizes cost of financing.

Solvency:

In a sound capital structure, content of debt will be a reasonable proportion of the total capital employed in the business. As a result, it has minimum risk of becoming insolvent.

Flexibility:

The capital structure of a firm should be such that it can raise funds as when required.

Conservatism:

The debt content in the capital structure of a firm should be within its borrowing limits. It should be free from the risk of insolvency.

Control:

The capital structure should be designed in such a way that it involves minimum risk of loss of control of the firm.

Optimal debt-equity mix:

Optimal debt-equity mix in the capital structure of a company would be that point where the weighted average cost of capital is minimum. Optimum debt- equity proportion establishes balance between owned capital and debt capital. The firm should be cautious about the financial risk associated with the maximum utilization of debt.

Maximization of the value of the firm:

An optimum capital structure makes the value of the firm maximum.

Features of Optimal Capital Structure:

a) The relationship of debt and equity in an optimal capital structure is made in such a manner that the market value per equity share becomes maximum.

b) Optimal capital structure maintains the financial stability of the firm.

c) Under optimal capital structure the finance manager determines the proportion of debt and equity in such a manner that the financial risk remains low.

d) The advantage of the leverage offered by corporate taxes is taken into account in achieving the optimal capital structure.

e) Borrowings help in increasing the value of company leading towards optimal capital structure.

f) The cost of capital reaches at its minimum and market price of share becomes maximum at optimal capital structure.

Constraints in Designing Optimal Capital Structure:

The capital structure of a firm is designed in such a manner that the cost of capital is kept at its lowest and the value of the firm reaches its maximum. The firm manoeuvers its debt-equity proportion to reach the optimum level. However in practice, reaching the level of optimum capital structure is a difficult task due to several constraints that appear on the way of implementing that structure.

The Main constraints in designing the optimum capital structure are:

  • The optimum debt-equity mix is difficult to ascertain in true sense.
  • The concept of appropriate capital structure is more realistic than the concept of optimum capital structure.
  • It is difficult to find an optimum capital structure as the extent to which the market value of an equity share will fall due to increase in risk of high debt content in capital structure, is very difficult to measure.
  • The market price of equity share rarely changes due to changes in debt-equity mix, so there cannot be any optimum capital structure.
  • It is impossible to predict exactly the amount of decrease in the market value of an equity share because market factors that influence market value of equity share are highly complex.

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