Optimal Capital Structure Essay

The optimal capital structure for a company should be the mix of equity, debt and hybrid instruments that minimizes the overall cost of funding, i.e. it should minimize the company’s weighted average cost of capital. In practice, however, it is not possible to specify this optimal capital structure exactly, for any individual company. It clearly makes sense to obtain funds at the lowest possible cost. In the long run, debt is cheaper than equity. However, when a company’s financial leverage increases as it takes on more debt capital, there is an increasing risk for stockholders. The cost of equity therefore will rise, perhaps offsetting the benefits of raising cheap debt capital. Although management cannot be specific about the optimal capital structure for their company, they should at least be aware of †¢how banks and the capital markets might respond to an increase in the company’s leverage level if it were to borrow new funds, and †¢Whether the company is sufficiently low geared to make new debt capital an attractive option, compared to a new issue of equity as a fund-raising measure. There are two approaches to managing a company’s capital structure: a reactive and a proactive approach. The reactive approach is to take funding decisions when a requirement for more—or less—funding becomes apparent, and to raise or reduce capital by the method that seems best at the time. The proactive approach that is found in companies with large and well-organized treasury functions is to †¢forecast future funding requirements or funding surpluses as much as possible †¢establish targets for capital structure, in particular a target leverage level (a target range) and a target maturity profile for debt capital †¢If appropriate, raise funds early when new funding requirements are anticipated, in order to take advantage of favorable conditions in the capital markets or low bank lending rates. This approach calls for accurate and flexible forecasting skills, and good treasury management systems. A proactive approach also can be taken to reducing funds, whenever a company considers its current funding to be in excess of requirements for the foreseeable, long-term future. By having a target leverage level and a target debt maturity profile, management can decide which method of removing surplus capital might be more appropriate, i.e. †¢reducing equity, by raising dividends or buying back and canceling stocks, or †¢Redeeming loans early. Company’s capital structure is never static and will change over time. Retained earnings that should be earned continually add to equity and reduce leverage levels. It is not unusual, therefore, for companies to experience funding cycles of high leverage, as new loans are obtained to fund capital expansion, and decreasing leverage, as retained earnings are earned. The cash flows generated from profits could be used to redeem loans and thereby replace debt capital with equity in the company’s capital structure.