# Discovering Optimal Capital Structure: Key Factors and Limitations Explored

> **Definition**
>
> Optimal capital structure diminishes a company’s weighted average cost of capital (WACC) and makes its market value as great as possible. It represents the most effective combination of debt and equity financing.

## What Is Optimal Capital Structure?

Optimal capital structure is vital for enhancing a company's market value by balancing debt and equity. By minimizing the weighted average cost of capital (WACC), companies strategically position themselves to lower funding costs and boost profitability. Understanding and navigating the dynamics of debt and equity aid in determining this equilibrium.

### Key Takeaways

*   Optimal capital structure is the ideal mix of debt and equity that minimizes a company's cost of capital and maximizes its market value.
*   The weighted average cost of capital (WACC) is central to determining a company's optimal capital structure, with the goal of achieving the lowest possible WACC.
*   Companies must balance the benefits of debt, like tax advantages, against the risks, such as increased possibility of bankruptcy.
*   While there is no fixed debt-to-equity ratio for optimal capital structure, it generally varies by industry, business type, and economic environment.
*   The Modigliani-Miller theory posits that in perfect markets, a firm's value is unaffected by its capital structure, highlighting the theoretical aspect of capital structure decisions.

![Optimal Capital Structure](https://www.investopedia.com/thmb/LOBGllxPBUwfG0PK1RevIHCDP4w=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Optimal-capital-structure_final-e29733f0e93846748c9d8662f1b247bb.png)

*— Michela Buttignol / Investopedia*

## Why Optimal Capital Structure Matters for Businesses

Optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the [weighted average cost of capital (WACC)](https://www.investopedia.com/terms/w/wacc.asp) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

According to economists [Franco Modigliani](https://www.investopedia.com/terms/f/franco-modigliani.asp) and [Merton Miller](https://www.investopedia.com/terms/m/merton-miller.asp), in the absence of taxes, [bankruptcy](https://www.investopedia.com/terms/b/bankruptcy.asp) costs, agency costs, and asymmetric information, in an efficient market, the value of a firm is unaffected by its capital structure.

## The Role of WACC in Determining Optimal Capital Structure

Debt costs less than [equity](https://www.investopedia.com/terms/e/equity.asp) because it carries less risk. The required return needed to compensate debt investors is less than the required return needed to compensate equity investors, because interest payments have priority over dividends, and debtholders receive priority in the event of a liquidation. Companies save on taxes with debt interest, making it cheaper than equity, which uses after-tax profits for dividends.

A company should limit debt, as too much raises interest costs, earnings volatility, and bankruptcy risk. This increase in the financial risk to shareholders means that they will require a greater return to compensate them, which increases the WACC—and lowers the [market value](https://www.investopedia.com/terms/m/marketvalue.asp) of a business. The optimal structure involves using enough equity to mitigate the risk of being unable to pay back the debt—taking into account the variability of the business’s [cash flow](https://www.investopedia.com/terms/c/cashflow.asp).

Companies with steady cash flow can handle more debt in their capital structure. In contrast, a company with unstable cash flows relies more on equity than debt.

## How to Identify the Best Capital Structure for Your Company

As it can be difficult to pinpoint the optimal capital structure, managers usually attempt to operate within a range of values. They also have to take into account the signals that their financing decisions send to the market.

A company with good prospects will try to raise capital using debt rather than equity, to avoid [dilution](https://www.investopedia.com/terms/d/dilution.asp) and sending any negative signals to the market. Announcements made about a company taking debt are typically seen as positive news, which is known as [debt signaling](https://www.investopedia.com/terms/d/debtsignaling.asp). If a company raises too much capital during a given time period, the costs of debt, preferred stock, and common equity will begin to rise, and as this occurs, the marginal cost of capital will also rise.

Potential equity investors assess risk by examining the [debt/equity ratio](https://www.investopedia.com/terms/d/debtequityratio.asp). They also compare the amount of leverage other businesses in the same industry are using—on the assumption that these companies are operating with an optimal capital structure—to see if the company is employing an unusual amount of debt within its capital structure.

Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the company into a credit profile using a bond rating. The bond's default spread indicates the risk above the AAA-rated company's risk-free rate.

## Understanding the Limitations of Achieving Optimal Capital Structure

There's no perfect debt-to-equity ratio for achieving the best real-world capital structure. What defines a healthy blend of debt and equity varies according to the industries involved, the line of business, and a firm’s stage of development, and can also vary over time due to external changes in interest rates and regulatory environment.

However, because investors are better off putting their money into companies with strong [balance sheets](https://www.investopedia.com/terms/b/balancesheet.asp), it makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity.

## Exploring Theories of Capital Structure

### Modigliani-Miller (M&M) Theory

The Modigliani-Miller (M&M) theorem is a capital structure approach named after Franco Modigliani and Merton Miller. Modigliani and Miller were two economics professors who studied [capital structure theory](https://www.investopedia.com/ask/answers/031915/what-capital-structure-theory.asp) and collaborated to develop the capital structure irrelevance proposition in 1958.

This proposition states that in perfect markets, the capital structure a company uses doesn’t matter because the market value of a firm is determined by its earning power and the risk of its underlying assets. According to Modigliani and Miller, value is independent of the method of financing used and a company’s investments. The [M&M theorem](https://www.investopedia.com/terms/m/modigliani-millertheorem.asp) made the following two propositions:

*   **Proposition I**: This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not be affected by the choice of financing adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes.
*   **Proposition II**: This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.

Though studied, the Modigliani-Miller theorem doesn't account for taxes, credit risk, or transaction costs, which affect financing choices.

### Pecking Order Theory

The pecking order theory focuses on asymmetrical information costs. This approach assumes that companies prioritize their financing strategy based on the path of least resistance. Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.

## Explain Like I’m 5 Years Old

Optimal capital structure is figuring out the perfect mix to make a company the best it can be. It means finding the right balance between borrowing (debt) and sharing (equity).

If you borrow too much, you might have trouble paying it back. If you share too much, you’ll have to share all the money you make.

Optimal capital structure helps you make the most money while managing the risk of borrowing.

## What Is the Goal of Optimal Capital Structure?

The goal of optimal capital structure is to determine the best combination of debt and equity financing that maximizes a company’s value. It also aims to minimize its weighted average cost of capital.

## What Is the Modigliani-Miller (M&M) Theory?

The Modigliani-Miller (M&M) theory states that capital structure has no impact on a company’s value, and is irrelevant in perfect markets where there are no taxes. This is due to the fact that a company’s value is based on its earning power along with the risk of its underlying assets.

## How Is a Company’s Capital Structure Evaluated?

Among the factors that are analyzed to determine the health of a company’s capital structure are its business risk, the capital structure of its competitors, and how its capital structure has changed over time.

## The Bottom Line

Achieving an optimal capital structure involves balancing debt and equity financing to maximize a company’s market value while minimizing the weighted average cost of capital (WACC). Although debt can offer tax advantages and lower costs compared to equity, excessive borrowing increases financial risk and the chance of bankruptcy, which raises the WACC. Companies must find the sweet spot where debt and equity together enhance profitability and attract investment, understanding that this balance may vary by industry, business model, and economic conditions.

Effectively managing this balance gives companies the best opportunity to increase shareholder wealth while managing financial risks.

> **Article Sources**
>
> 1.  Modigliani, Franco, and Merton H. Miller. “[The Cost of Capital, Corporation Finance, and the Theory of Investment](https://gvpesquisa.fgv.br/sites/gvpesquisa.fgv.br/files/arquivos/terra_-_the_cost_of_capital_corporation_finance.pdf).” _The American Economic Review_, vol. 48, no. 3, 1958, pp. 261–297.
>     
> 2.  Modigliani, Franco, and Merton H. Miller. “[The Cost of Capital, Corporation Finance, and the Theory of Investment](https://gvpesquisa.fgv.br/sites/gvpesquisa.fgv.br/files/arquivos/terra_-_the_cost_of_capital_corporation_finance.pdf).” _The American Economic Review_, vol. 48, no. 3, 1958, pp. 268–271.
>     
> 3.  Modigliani, Franco, and Merton H. Miller. “[The Cost of Capital, Corporation Finance, and the Theory of Investment](https://gvpesquisa.fgv.br/sites/gvpesquisa.fgv.br/files/arquivos/terra_-_the_cost_of_capital_corporation_finance.pdf).” _The American Economic Review_, vol. 48, no. 3, 1958, pp. 271–276.