Optimal Capital Structure Definition: Meaning, Factors, and Limitations
What is the Definition of Capital Structure?
Capital structure is a word that is used to describe how a business funds its day-to-day operations as well as its future expansion. It includes the use of both debt and equity to support the firm and may have a significant influence on the profitability of any organization. The correct mix of debt and equity may be beneficial to a company since it can provide long-term sustainable finance while also allowing for flexibility during periods of economic uncertainty or market instability.a
When businesses are deciding how much debt vs equity they want to have in their capital structure, they take into consideration a variety of aspects, including their level of comfort with risk, the interest rates that are now in effect, the state of their finances, and their credit ratings.
What is Optimal Capital Structure?
The optimal capital structure is a crucial aspect of any organization, since it may have a substantial impact on a company's long-term success or failure. When it is properly managed, having the optimal capital structure may assist businesses in increasing their earnings while simultaneously reducing their risk exposure. But what does "optimal capital structure" really mean?
The term "optimal capital structure" refers to the ideal mix of debt and equity that a company utilizes to fund its day-to-day business activities, as well as its expansions and investments. The term "debt" is used to refer to the act of borrowing money from creditors such as banks or other financial organizations, while the term "equity" is used to refer to the ownership of a firm by its shareholders. In order to achieve the goals of maximizing profits while simultaneously limiting risk, a capital structure that is well-structured must strike a balance between these two sources of financing. The optimal capital structure is determined by a variety of elements, such as market circumstances, tax rates, industry norms, access to debt funding, and the overall financial health of the company. When evaluating the optimal proportion of debt to equity for their finances, businesses need to take into account their expected rates of development as well.
Optimal Capital Structure Characteristics
The capital structure should be adaptable to allow for changes whenever the situation calls for them. If a company wishes to grow its operations or scale down some of its activities, for instance, it needs a capital structure that allows for either of those things to happen. In most cases, growth in capital does not provide a challenge; nonetheless, a decrease in the capital is notably hard to accomplish. Equity capital is regarded as holy and may not be lowered unless in compliance with the rules of the Companies Act of 1956. A capital structure may be made more adaptable by issuing securities with redemption features, such as redeemable preference shares or debentures.
A Balance between Debt and Equity
The optimal capital structure maintains a healthy balance between the use of equity financing and debt financing. A firm should not place an excessive amount of reliance on debt since doing so exposes it to the possibility of incurring significant interest charges as well as the danger of going bankrupt. In the same manner, placing an excessive amount of reliance on equity might result in ownership being diluted and a decrease in profits per share. As a result, in order to reduce the cost of capital and maximize the value of the company, it is vital to maintain a healthy balance between debt and equity.
The perfect or optimal capital structure needs to be one that is distinguished by its degree of straightforwardness. In this context, "simplicity" refers to the requirement that initial capital should be raised via a limited number of different forms of instruments; hence, only equity and preference shares should initially be issued, while debentures should be issued later on.
Thus, diversification insecurities should be implemented progressively with the business's growth. The trust of the investors will increase as a result, and it will be much simpler to get financial backing.
In addition to this, along with keeping the capital structure basic, it should also be kept in mind that it may not become much cheaper than the necessity.
A strong capital structure protects a company against a number of risks, including inflation, rising interest rates, taxes, and price decreases. These dangers may be reduced to a manageable level by implementing the necessary modifications to the various components of the capital structure.
Limitations of the Optimal Capital Structure
Unfortunately, the optimal capital structure is not a rigid and predictable concept. The truth is that the corporate world is volatile and ever-evolving. The company's capacity to reach its ideal capital structure may be influenced by external factors such as fluctuating interest rates, inflation, rivalry in the market, and regulatory restrictions.
A further limitation of the optimal capital structure is the possibility that it cannot be achieved by all businesses. An optimal capital structure may be difficult to attain depending on factors including a company's size, industry, and stage of growth. For instance, a small firm that is just getting started may not have access to the same quantity of debt or equity as a huge company that has already been operating for a long time, which might make it challenging for the small company to reach the optimal capital structure.
In conclusion, although the concept of optimal capital structure is helpful for understanding the best mix of debt and equity, it is crucial to acknowledge that it may not always be feasible in reality owing to the dynamic and unpredictable nature of the business environment, as well as other variables that may impact a company's financing decisions.
Example of Optimal Capital Structure
Aditya gets started on his mission to determine the financing structure that would work best for his organization. The first thing he does is calculate his liabilities. Loans, costs, taxes, and warranties are some examples of liabilities. Deferred revenue and wages are further examples of liabilities. The following is a list of the yearly liabilities associated with his organization tinfoil:
$100,000 in mortgages
$25,000 in liabilities to suppliers
$200,000 in wages
$10,000 in taxes
The yearly liabilities of Tinfoil come to a total of $335,000. On the other hand, equity is equal to the value of all assets minus the value of all liabilities. A company's assets are its resources and property that can be quickly and easily transformed into cash. Examples of liquid assets include cash, inventory, and other readily available goods. Due to the fact that Tinfoil's assets total $1,000,000, the amount of equity in the firm is calculated as follows: $1,000,000 - $335,000 = $665,000.
So, the formula for the debt-to-equity ratio is liabilities/equity. Aditya desires the ratio of Tinfoil to be 1/1, which is equivalent to 1. At the present time, Tinfoil has a debt-to-equity ratio of 335,000/665,000, which equals 0.5. Aditya may therefore use the company's assets to help him arrive at the ideal capital structure. Let's examine how he restructured his debt to pay for the firm's improvements and achieve his target of a debt-to-equity ratio of 1.
Aditya came to the conclusion that it was best for the firm to raise its mortgages. He adds $330,000 to both his assets and liabilities. The following are some of the yearly liabilities that are currently held by the company:
$430,000 in mortgages
$25,000 in liabilities to suppliers
$200,000 in wages
$10,000 in taxes
The yearly liabilities of Tinfoil are $665,000. Due to the fact that Tinfoil now owns assets worth $1,330,000, the company's equity is calculated as follows: $1,330,000 - $665,000, which equals $665,000. At this time, Tinfoil's debt-to-equity ratio is 665,000/665,000, which equals 1. So, Aditya has now arrived at the ideal capital structure for Tinfoil by expanding the firm's mortgages in order to fund the many projects being undertaken by the company.
What is the right debt-to-equity ratio?
It is essential to keep in mind that the ideal capital structure might look quite different from one sector to the next. The ratio should stay close to 1 for most economic sectors. This keeps a company from being suffocated by its debt. There are, however, several notable deviations from the rule. For instance, businesses that are tasked with the financing of long-term projects need a greater share of the ownership. They are often extremely big corporations that engage in endeavors with a long time horizon with the hopes of generating a return at some point in the future. As examples, we may look at initiatives in the education, banking, and transportation sectors, as well as the manufacturing sector.
The capital structure of a firm is influenced by a number of different circumstances, and the combination of debt and equity that makes up this structure is likewise decided by these factors. The following is an example of some of these contributing factors:
Cash Flow Position
The capacity of the company to create an adequate amount of cash flow should be taken into consideration before making any decision related to the composition of the capital structure.
The company is required by law to pay debenture holders a fixed rate of interest, dividends to preference shareholders, and principal and interest to loan holders. Occasionally a corporation may produce a substantial profit, but it will be unable to create enough cash flow to cover its payment obligations.
If a firm is unable to meet its payment obligations, the company might run the risk of becoming bankrupt, hence the anticipated cash flow and payment obligations need to be in line with one another. Before a firm can even consider adding debt to its capital structure, it has to conduct an accurate analysis of the liquidity of its working capital.
Interest Coverage Ratio
The Interest Coverage Ratio is the number of times a company's EBIT (earnings before interest and taxes) covers its interest payments.
ICR is calculated by taking the EBIT and dividing it by the interest.
When the interest coverage ratio (ICR) of a company is higher, the danger of not being able to satisfy its interest payment obligation is lower. This enables the company to take on more debt.
In the event that the ratio is lower than desired, businesses should use less debt.
Return on Investment
Another essential component that contributes to the formation of the capital structure is the rate of return on investment. If a company's return on investment is higher than the rate of interest that must be paid on its debt, the company should prioritize debt in its capital structure. On the other hand, if the return on investment is lower than the rate of interest that must be paid on its debt, the company should steer clear of debt and rely instead on equity capital.
The expense incurred in the issuance of shares or debentures is referred to as the floatation cost. Among these charges are those associated with advertising, underwriting, statutory fees, and other associated expenses.
The issuance of shares and debentures requires the completion of additional procedures and causes a rise in the flotation cost. On the other hand, acquiring funds via loans or advances will cost you less than other methods.
Equity share financing may not be used by management if it desires no outside influence on its operations. Equity shareholders not only diminish the ownership position of existing owners in the firm but also have the power to vote for and nominate directors. When it comes to funding their operations, some businesses could choose the use of debt instruments. It will be impossible for the creditors to interfere with the operations of the company if they are paid the installments on the loans and the interest that they are owed on time. But, if the firm fails to make its credit payments as agreed, the creditors have the ability to remove the current management and seize control of the company.
The SEBI guidelines must be followed while issuing shares and debentures, and when obtaining loans Businesses are obligated to act in accordance with the guidelines set out by the monetary policies. If the criteria set out by SEBI are simpler, then businesses could decide to raise extra capital via the issuance of securities. On the other hand, if monetary policy is made more flexible, then businesses might choose to take out a greater number of loans.
Stock market conditions
There are two primary states that the market might be in, which are referred to as the Boom condition and the Recession or Depression condition. These factors have an effect on the capital structure, particularly when the firm is trying to issue additional capital.
Borrowed money securities are preferable during market downturns because they are less hazardous and provide fixed repayment and regular payment of interest. On the other hand, equity shares are preferred during market upturns because investors are willing to incur greater risk in exchange for higher dividend payouts.
Capital Structure of Other Companies
There are certain businesses whose capital structures are organized in accordance with the standard for their industry. Yet, appropriate precautions need to be made since mindlessly following the standard of the industry might put one's finances in danger. If a company cannot afford to take on significant risk, it is not advisable for that company to obtain more debt just because other companies are doing so.
The debt-to-equity ratios of other companies operating within the same industry might serve as a helpful reference when establishing the capital structure of a business.
Management should be aware of industry standards and should either stick to them or have a good reason for deviating from them.
One of the most important considerations is inflation. The price of a company's raw materials, energy or power usage, transportation, equipment, and machinery all go up when there is an unexpected increase in demand for the company's products and services. A very modest increase in the cost of these expenditures has the potential to have a detrimental effect on both the firms' budgets and their levels of output. So, it is abundantly clear that a business organization has to design the most effective capital structure possible in order to account for the unpredictability of inflation.
Theories on Capital Structure
Modigliani-Miller (M&M) Theory
The M&M theorem is an approach to capital structure that was developed in the 1950s and is named after the economist's Franco Modigliani and Merton Miller. Modigliani and Miller were two professors at Carnegie Mellon University's Graduate School of Industrial Administration (GSIA) who studied capital structure theory and collaborated to formulate the capital-structure irrelevance proposition.
In 1985, Modigliani received the Nobel Prize in Economics for his contributions to the field. His other work also helped him win the Nobel Prize. In 1990, Merton Miller also received the Nobel Prize in Economics for his groundbreaking work in the field of financial economics and for his contributions to the Modigliani-Miller Theorem (M&M).
According to this theory, a company's market value in perfect markets is independent of its capital structure since it is based on the earnings potential and risk of its underlying assets. According to Modigliani and Miller, a company's value may be determined independently of the kind of financing that it employs and the investments that it makes. The M&M theorem produced two different statements, which are as follows:
According to this proposition, the importance of a company's capital structure to the overall value of the company is totally irrelevant. The method of financing used to fund the assets would have no impact on the value of two identical companies. The anticipated levels of a company's future profits are a primary factor in determining the value of that company. It's when there are no taxes to pay.
According to this proposition, a company's value may be increased while simultaneously lowering its WACC via the use of financial leverage. It is when tax information is available.
Pecking Order Theory (POT)
Pecking order theory is a theory pertaining to the capital structure of the firm where the management is expected to follow a predetermined hierarchy when picking the sources of finance in the company where the first priority is given to internal financing, then to external sources when enough funds cannot be generated via internal financing where debt issuance will be considered first to produce funds and finally to equity if the funds are not enough.
The ideal composition of a company's financial resources is one of the most important contributors to that organization's overall success. When determining how much debt and equity to utilize, businesses need to take into account their unique goals and objectives. It is essential to keep in mind that there is no "one size fits all" solution to this question. At the end of the day, the objective ought to be to bring the cost of capital down as much as possible while simultaneously increasing the wealth of shareholders. Consider all of the possibilities that are open to you, and discuss them with an experienced financial counselor, so that you may establish the optimal balance for your company.