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Capital structure is regarded as the amount of debt and equity used by financial organizations to fund business operations and their assets. This method is widely viewed as debt to equity or debt to capital ratio. This method is used by a firm in funding business operations and the acquisition of valuable assets.
In most business settings, capital structure is different based on the industry’s identity and specialization. There are three methods of capital structure, which are risk-taking in business, the cost of capital and investment, and control of valuable and financial business assets. Capital structure decides the mix of debt and equity in the long term.
Optimal capital structure is the best structure a company can initialize. It maximizes the value of the company’s assets and minimizes the cost of business spendings. The company is in charge of laying down different various options that will best fit its business agenda. If the company is in debt, it will affect the capital structure which can affect business decisions taken. This makes it important for companies to select appropriate capital structures in other to maximize their profit wisely.
The key component of optimal capital structure is business risk. This prepares a firm to face the challenges of business operations and cash investments opportunities. It lowers the tax liability of a company. A strong balance sheet enables a company to understand its strength in other to be financially stable. The managerial decision of the company’s operation helps encourage the use of this method, in other to boost profit.
Capital structure is the combination of different types of capital used by a firm, which would minimize the firm’s cost of capital and also maximize its value (Besley, S., & Brigham, E., 2015, page 448). It is also referred to as the amount of debt and/or equity required by an organization to fund its daily activities and finance its assets. It conveys a firm’s debt-to-equity or debt-to-capital ratio. A firms’ business operations, investments, capital expenditures are funded by debt and equity capital. Firms have to decide on a balance where one thing increases, and another must decrease when they decide whether to use debt or equity to finance operations, and managers would need to balance the two to derive an optimal capital structure. The percentage of debt and equity to get the lowest weighted average cost of capital (WACC) of an organization is known as the optimal capital structure of a firm.
The following considerations will assist a finance manager to ascertain the amount of optimum capital structure;
- Advantage of Corporate Taxes: Equity financing is high-priced compared to the low-priced debt financing due to the allowances authorized by the corporate tax authorities.
- Advantage of Financial Leverage: On condition that the return on investment is relatively higher compared to the fixed cost of funds, a finance manager would consider fundraising, although there is a fixed cost of finance, as the equity shareholders would be a beneficiary.
- Avoidance of High-Risk Capital Structure: Risk would occur when the proportion of debt capital is more than owned capital.
- Advantages of Debt-Equity Mix: The advantage of debt-equity mix would be taken by a finance manager in the form of capital structure to find out the optimum capital structure of a firm. Once the optimum capital structure is achievable, the finance manager is free from financial issues and ensures the proper usage of debt-equity mix has been attained.