Optimal Capital Structure

Instructor: Betty Fitte

Betty teaches college business management and finance courses and has senior management business experience.

There are multiple approaches and perspectives in defining an optimal capital structure. In this lesson, we will examine two important perspectives: raising capital and servicing capital.

What is Optimal Capital Structure?

Sir Winston Churchill once said; ''Sometimes doing your best is not good enough. Sometimes you must do what is required.'' So, what is required and what is best for a company's capital structure? Like many answers, it depends.

Optimal capital structure typically refers to the best mix of debt and equity to fund a business. For a company, optimal capital structure depends on:

  • The intended exit strategy for the business.
  • The current capital structure.
  • The projected capital needs.

There are multiple approaches and perspectives here. Let's examine optimal capital structure from two important perspectives: raising capital and servicing capital.

Note that financial analysts may treat elements of debt and equity differently. For this lesson all types of debt (short or long term, subordinated, etc) and all forms of equity (preferred or common stock, retained earnings, etc) are treated equally.

A Scenario

Say your company is riding an upward trend in its market. The prospects for continued growth are strong and your CEO wants to take full advantage of the current opportunities. She believes that investment in expansion is in order.

New facilities and operating cash for the expansion is estimated at $50 million. A debt to equity ratio is a simple calculation of all debt divided by all equity of the company. A snapshot of your company's current capital structure reveals a debt to equity ratio of .41 (35,000/85,000).

CURRENT DEBT-EQUITY SCHEDULE $ (000)
ASSETS $150,000
LIABILITIES (Short and Long-Term Debt) $35,000
EQUITY (Common and Preferred Stock) $65,000
Retained Earnings $20,000

How do you propose the optimal capital structure for the $50 million expansion? As the chief financial officer, you begin by considering two important perspectives: The relative ease or difficulty of obtaining (raising) debt vs equity capital and the relative, ongoing cost of servicing either debt or equity.

The company stock is currently owned by private investors whose exit strategy is to one-day issue company stock on the public markets. The current thinking is to continue to build market value for the company's brand, assuring a successful initial public offering (IPO).

Current debt includes $15 million in bonds that mature in 20 years, and pay 10% interest annually to the bond holders. The remaining $20 million of debt is in bank loans, in good standing with well-known financial institutions. The relatively low interest payments of 5% are managed from the company operating income.

You wonder - how much more debt would these institutions be willing to lend you?

The company has accumulated retained earnings of $20,000,000 in its 10 years of operation. The company pays 30% corporate taxes and enjoys the reduction of $750,000 in taxes annually as a result of the current structure. ((15,000,000 * .1 + 20,000,000 * .05) * .3)

Knowing the long-range plan for an IPO, you look to the markets to help you determine what could be expected from an IPO. You know that your closest competitor recently completed its IPO, going out at $10 per share, and today the market price is more than doubled at $25 per share. You wonder - is now the right time for your IPO?

Raising Capital Vs. Servicing Capital

You remember that the optimal capital structure is the best combination of debt and equity financing for a company, commonly expressed as the debt to equity ratio. Factors to consider:

Raising capital

  • Lending institutions look at a business' debt ratio to help them determine the level of risk. Your company's debt ratio is currently 23% (35,000,000 / 150,000,000) and considered acceptably low by your lenders. However, they have cautioned you to keep this ratio under 50% to maintain your low rate of interest.
  • Your current investors have been funding the company since inception and have made it clear that they are against dilution of their stock, prior to the planned IPO. Additional private equity funding would therefore come at a much higher price to the company. Underwriting costs of an IPO are estimated at 5 - 6% of proceeds plus at least $1million of one-time legal and accounting fees.

Servicing capital

  • Interest rates on a bank loan are expected to be the current 5%. Additional bonds could be issued. The current climate for bonds is favorable for businesses and could be sold for 8% interest maturing in 20 years.
  • In an IPO scenario, the company would be new at operating in the public markets and estimated costs for reporting requirements and administration of trade regulations is estimated at $1.5 million annually.

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