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VMC: What Is Optimal Capital Structure?

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Definition of Optimal Capital Structure

  • The optimal capital structure of a firm is the right combination of equity and debt financing.
  • It allows the firm to have a minimum cost of capital while having the maximum market value.
  • The lesser the cost of capital, the more the market value of the company.
  • Debt financing may have the lowest cost, but having too much of it would increase risks to the shareholders.
  • So, firms need to find a balance between both to benefit from it entirely.

What Impacts the Optimal Capital Structure?

  • WACC
  • Cost of debt
  • Cost of equity 

How to Calculate the Optimal Capital Structure?

  • There is no specific formula to find the optimal capital structure, but what can be done is minimizing the WACC by listing out all the possibilities.
  • Because it is tax-deductible, debt financing tends to have a lower cost than equity financing.
  • However, it has to be kept in mind that having too much debt financing will affect the level of risk the company has.

Why is the Optimal Capital Structure Important?

  • Firms that can manage to have an optimal capital structure would benefit from having more market value while having the minimum cost.
  • Firms need to have it because no firms want to be paying too much money for less value.

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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.