We are independent & ad-supported. We may earn a commission for purchases made through our links.
Advertiser Disclosure
Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.
How We Make Money
We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently of our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.

What is Optimal Capital Structure?

By Deanira Bong
Updated May 16, 2024
Our promise to you
SmartCapitalMind is dedicated to creating trustworthy, high-quality content that always prioritizes transparency, integrity, and inclusivity above all else. Our ensure that our content creation and review process includes rigorous fact-checking, evidence-based, and continual updates to ensure accuracy and reliability.

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

Editorial Standards

At SmartCapitalMind, we are committed to creating content that you can trust. Our editorial process is designed to ensure that every piece of content we publish is accurate, reliable, and informative.

Our team of experienced writers and editors follows a strict set of guidelines to ensure the highest quality content. We conduct thorough research, fact-check all information, and rely on credible sources to back up our claims. Our content is reviewed by subject-matter experts to ensure accuracy and clarity.

We believe in transparency and maintain editorial independence from our advertisers. Our team does not receive direct compensation from advertisers, allowing us to create unbiased content that prioritizes your interests.

A firm finances its activities using funds from debt and equity. Debt refers to loans the firm secures from outside sources. Equity refers money the firm's owners or stockholders invest in the firm. A firm's capital structure is its ratio of long-term debt to equity. An optimal capital structure is the best debt-to-equity ratio for the firm, which minimizes the cost of financing and maximizes the value of the firm.

According to the trade-off theory, the cost of debt is always lower than the cost of equity, because interest on debt is tax-deductible. The cost of equity usually consists of dividends the firm distributes to its owners or shareholders — dividends the firm could delay or reduce. Debt-holders have a prior claim to the firm's funds, and the firm can only pay shareholders after meeting its debt obligations for the period. Debt is cheaper but carries with it the risk of not being able to make payments on time, which could result in bankruptcy. The firm, therefore, has to find an optimal capital structure that minimizes the cost of financing while also minimizing the risk of bankruptcy.

A firm's capital structure can be found mathematically by computing its minimum weighted average cost of capital. For example, if a company uses debt at 4 percent to get 30 percent of its funds and equity at 10.5 percent to get 70 percent of its funds, the firm's weighted average cost of capital is (0.30 X 4 percent) + (0.70 X 10.5 percent) = 8.55 percent. The formula implies that the firm can get a minimum weighted average cost of capital of 4 percent by using debt as its sole source of funds, but it would not be the firm's optimal capital structure because the firm would then face a high risk of bankruptcy.

Other factors also contribute to the unworkable nature of trying to achieve optimal capital structure by using only debt to finance a firm's activities. When a firm increases its debt-to-equity ratio, lenders usually become concerned about the ability of the firm to meet its payments. They then increase the interest rate on the firm's loans. Shareholders also become concerned about bankruptcy and insist on getting a higher rate of return. Both the cost of debt and equity would increase, increasing the weighted average cost of capital.

If a firm knows the cost of equity and debt at all possible levels of debt-to-equity ratio, it could calculate the point at which it gets a minimum weighted average cost of capital, which is its optimal capital structure, according to the trade-off theory. If the firm has a lower debt-to-equity ratio than the optimal level, it would be paying too much for its funds and could decrease the cost of capital by borrowing more money. If it has a higher debt-to-equity ratio than the optimal level, it would also be paying too much for its funds, because lenders and stockholders perceive the firm as being too risky, and the firm could decrease the cost of capital by paying its debt or issuing new equity.

Critics of the trade-off theory disagree that the optimal capital structure can be found using this method. They say that, in real life, shareholders, lenders and managers might not always behave according to the theory. There is an asymmetry of information whereby lenders and shareholders know less about the firm than the managers, who might not act in the firm's best interests.

SmartCapitalMind is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
Discussion Comments
By Glasis — On Jan 26, 2014

Critics of the optimal capital structure method definitely have an argument, especially when it comes to financially distressed or bankrupt companies.

Bankruptcy law gives payment priority to debt holders over shareholders. As a result, shareholders often get nothing from a bankrupt company, especially when the company cannot afford to fully repay its lenders and other debt holders.

Many bankrupt companies also trade a portion of their debt for new equity. In this case, the existing equity is usually rendered worthless.

It is hard to find an optimal capital structure balance when management has the luxury of ignoring shareholders.

SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.

SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.