Optimal capital structure

Optimal capital structure is a balanced set of dept and stock that helps to maximize company value (or stock price). The benefit of debt is lowest cost of capital, but accompanied with higher financial risk to shareholders. Therefore company should find an equilibrium when benefit of debt is similar to marginal cost.

Measuring capital structure

The most popular measure that helps to optimize capital structure is WACC (weighted average cost of capital). It is a calculation of a firm's overall cost of capital in which each category of capital is proportionately weighted. All capital sources - stocks, bonds and any other long-term debt - are included in a WACC calculation.

\(\text{WACC} = \left ({E \over {V}}\right) \cdot r_E + \left ({D \over {V}} \right) \cdot r_D \left (1-T_c\right)\)

where:

  • \(\ D \) is the value of debt,
  • \(\ E \) is the value of equity,
  • \(\ V \) is the market value of the company,
  • \(\ T_C \) is the tax rate,
  • \(\ r_D \) is the cost of debt,
  • \(\ r_E \) is the cost of equity.


References

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