Does Your Company Have the Right Capital Mix?

Have you ever wondered what the secret is to increase a company's wealth while keeping its cost of capital at its lowest?

The answer is an optimal capital structure. 

It is a strategic mix of debt and equity that maximizes financial success and minimizes risk. This blend maximizes the company's wealth and worth while keeping its cost of capital at its lowest. 

By striking this delicate balance, companies can:

  • Enhance their financial stability
  • Attract investors
  • Pave the way for sustainable, long-term growth

How do you calculate Optimal Capital Structure?

You can calculate a company's optimal capital structure by finding the mix of debt and equity that produces the lowest Weighted Average Cost of Capital (WACC). 

A lower WACC means : 

  • The company can finance its operations at a cheaper cost
  • It leads to higher future cash flows 
  • Increased shareholder value

In essence, the optimal capital structure is the sweet spot where a company can reap the benefits of both debt and equity financing without overburdening itself with excessive debt. Nor do you sacrifice control to equity investors. 

As stated by Modigliani's Miller theorem, in a perfect world without taxes, bankruptcy, or information imbalances, a company's value is not affected by how it chooses to finance itself.

Top 4 Factors to Consider While Creating an Optimal Capital Structure

  • Maximize shareholder wealth: Enhance your company's value, which directly translates to greater shareholder wealth. 
  • Minimize risk of insolvency: Reduce your overall financial risk and lower the likelihood of insolvency. A solid capital base can act as a safeguard, particularly for industries with unpredictable cash flows.
  • Simplicity & clarity: An optimal capital structure should be straightforward to understand and implement to avoid unnecessary complexities. 
  • Maintain ownership control: Balancing debt and equity allows shareholders to participate in the company's growth and decision-making without taking on too much debt.

Relationship between WACC and Optimal Capital Structure

WACC represents the average cost a company incurs to finance its assets, considering the cost of debt and equity capital.

Optimal Capital Structure is a mix of debt and equity that minimizes a company's cost of capital and maximizes its value. Finding the optimal capital structure involves balancing the benefits of debt (interest tax shields, lower cost) against the costs (financial distress, agency costs). 

It goes without saying that WACC and optimal capital structure are closely related concepts.

  • As a company adjusts its capital structure, WACC also changes. 
  • Typically, more debt in the capital structure decreases WACC due to the tax shield benefit of interest payments, which reduces the overall cost of capital.
  • However, more debt also increases the risk of financial distress, which may lead to higher costs of equity capital (Re) due to increased risk perception by equity investors. This increase in Re can offset the benefit of debt and raise the overall WACC.
  • Conversely, reducing debt in favor of equity may increase WACC due to the higher cost of equity capital. 
  • However, it may lower financial risk, reducing the potential for financial distress and associated costs.

Simply put, a company's optimal capital structure is the mix of debt and equity that results in the lowest WACC. This optimal point maximizes the firm's overall value and shareholder wealth.

Recur Insight - Companies shouldn't just calculate an optimal capital structure once. Regularly revisiting and potentially adjusting the debt-to-equity mix based on evolving circumstances can help them stay on the path to maximizing value.

Are you looking to fill the debt part of that component? Recur Club can help! 

Reach out to our capital experts here and get a step closer to building that optimal capital structure.

Pragya Pokhriyal