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Monday, February 12, 2018

Optimal Capital Structure

Background

An organization needs two types of financial resources to invest in assets. One is short term source of financing and another is long term source of financing. Basically  the liabilities that are payable with in one year are called shot term financing and the liabilities that are payable with in more than one year period are called long-term source financing. 


The aggregate of short-term and long-term financing is called Total Financing. And the ratio of difference sources in total financing is called Financing Structure.  With in the financial structure, only the portion of long-term source of capital is called capital structure. 

Sources of long term financing.


  1. Equity share capital
    It is main long term source of capital for many companies. It is irredeemable or perpetual source of capital. Company ought not to bear fixed cost of capital on it. It means the cost(return) is not prefix on equity share capital. Equity shareholders are owner of the company. They participate on the residual income of the company.  Though the cost is not fixed on it, it is costly source than others because equity shareholder has claim on residual income and assets after paying other liabilities. Company pays dividend on it. ( See also : What is Rights Offering ? Options to shareholders and its effect on their wealth )
  2. Long-term Bond/debenture 
    Company pays interest on long-term bond/debenture. Company must pay interest to the debenture holder/bondholder no matter there is profit or loss. The interest rate may be fixed for every year until maturity. The interest might be tied up with market interest rate.
    Note : The bond/note/debenture that has interest rate tied up with market interest rate especially with interest rate on government securities is called Floating Rate Note (FRN).
  3. Preference share capital
    It is hybrid kind of capital that has mix kind features of equity share capital and debenture. It has fixed rate of dividend but the claim is subordinated to debenture holders. 

Determining Optimal Capital Structure


The portion of long term financing sources on total capitalization is called capital structure. For example, if there $200000 Common stock, $150000 Preference share capital, $150000 Debenture, the summation of all these source $500000 is called total capitalization. And among the total capitalization, 40% Common stock, 30% Preference Share, 30% Debt is called capital structure.

Optimal Capital Structure
Change in capital structure implies change in cost of capital. But Why and How ? First, using debt implies low cost of capital in initial time because debt capital has lower cost than that of share capital. But when we regularly increase the use of debt, there will be lower liquidity on an organization. As a result cost of debt should be increased and that implies increase in cost of capital. Second, Making increase in debt capital implies higher risk on equity shareholders investment and their expected rate of return goes higher, the cost of capital also goes higher. 

According to above discussion, we can conclude that, the capital structure where the cost of capital becomes minimum and value of firm becomes maximum is called optimal capital structure.

We have to calculate Weighted Average cost of capital(WACC) to determine optimal capital structure.

WACC= Weight of Debt*after tax cost of debt+ Weight of equity* Cost of equity.

Now we have to take a look in to following table become more clear about optimal capital structure.

Calculation of WACC


In the above table the cost of capital is 12% when there is no use of debt. Then after we use debt capital 10% and reduce equity capital to 90%, the cost of capital reduced to 11.78%. The cost of capital is reduced till we use 20% debt. But when we increase the use of debt to 30% from 20%, the cost of capital started to increase. It means use of debt can reduce cost of capital to a limit only. The cost of capital is minimum when we structured our capital using 20% Debt and rest 80% Equity share capital which is Optimal Capital Structure.


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