Optimal Capital Structure: Definition, Formula & Estimation Video

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  • 0:04 What Is Optimal…
  • 0:55 Finding Optimal…
  • 3:16 Debt-to-Equity Ratio Decisions
  • 4:39 Lesson Summary
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Lesson Transcript
Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

Find out how to leverage assets to increase profits. Using the optimal capital structure, you will work through an example of finding the perfect ratio using assets and liabilities. Learn how to determine equity and find the debt-to-equity ratio.

What Is Optimal Capital Structure?

Jason wants his company to achieve an optimal capital structure, also known as the target capital structure, while financing several large infrastructure projects. Jason works for Tinfoil Equipment, which makes fire and rescue equipment. The company wants to invest in new, light-weight equipment. To make this happen the company has to upgrade its three manufacturing sites. This is a hefty investment for the company. Jason needs to make use of what is called the optimal capital structure, which is a debt-to-equity ratio that maximizes a company's value. A debt-to-equity ratio tells us the proportion of a company's liabilities to equity. Liabilities are all of the short- and long-term debts incurred by a company. Jason's company is a medium-sized company so he is striving for the company's liabilities to equal equity. This results in a ratio of 1.

Finding Optimal Capital Structure

Jason begins his endeavor of finding the company's optimal capital structure. He starts with determining his liabilities. Examples of liabilities are loans, expenses, taxes, warranties, deferred revenue, and wages. Tinfoil has the following annual liabilities:

  • $100,000 in mortgages
  • $25,000 in liabilities to suppliers
  • $200,000 in wages
  • $10,000 in taxes

Tinfoil's annual liabilities total is $335,000. Equity, on the other hand, is the value of all assets minus liabilities. Assets are those items a company has that can be converted into cash within a year. Examples are cash, inventory, and liquid assets. Tinfoil has $1,000,000 in assets, which makes the company's equity $1,000,000 - $335,000 = $665,000.

The debt-to-equity ratio equation, therefore, is liabilities/equity. Jason wants Tinfoil's ratio to be 1/1, which equals 1. At the moment, Tinfoil has a debt-to-equity ratio of 335,000/665,000, which equals 0.5. So Jason has some room to leverage the company's assets to reach an optimal capital structure. Let's see how he restructured his debt to finance the company's upgrades and meet his goal of a debt-to-equity ratio of 1.

Jason decided to increase the company's mortgages. He restructured the debt so the company had the following annual liabilities:

  • $430,000 in mortgages
  • $25,000 in liabilities to suppliers
  • $200,000 in wages
  • $10,000 in taxes

Tinfoil's annual liabilities total $665,000. Equity, on the other hand, is the value of all assets minus liabilities. Tinfoil has $1,000,000 in assets, which makes the company's equity $1,000,000 - $665,000 = $335,000. Now Tinfoil has a debt-to-equity ratio of 335,000/335,000, which equals 1. So Jason has now reached an optimal capital structure for Tinfoil by increasing the company's mortgages to finance the company's projects.

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