Optimal capital structure: what it is – Dictionary of Economics

Definition of Optimal Capital Structure

This is a matter widely discussed by financial theory. Basically, it could be defined as that combination of own and external resources that maximizes the value of the company, or expressed in other terms, what indebtedness would be reasonable to achieve a higher valuation.

According to some authors (Modigliani and Miller pe) it would not be possible to add value via an increase in indebtedness, while for others it would be possible. In general, what can be said is that:

– In companies with a high return on assets (ROA), the capacity for indebtedness is higher and therefore the shareholder might prefer the company to borrow rather than resort to increasing its own funds.

– In those companies with low ROA or very long-term profitability, financing through debt can endanger the stability of the company and, therefore, the percentage of the investment to be financed through debt should be low.

Two other factors must be taken into account:

– The fact that the debt interest burden is tax deductible generates tax savings known as Tax Shield and in itself is a positive value for the company.

– Indebtedness increases the possibility of non-payment, and therefore of suspension of payments/bankruptcy of the company, so it will be necessary to see if the Tax Shield is lower or higher than these costs that will generate the possibility of bankruptcy (translated into a higher cost of financing).

Closely linked to the optimal financing structure is the concept of cost of capital, given that in it own funds imply a higher cost due to their greater risk relative to debt. Indebtedness, as long as it is moderate, means reducing the cost of capital and therefore increasing the value of the company.

In short, the optimal capital structure is a very important concept in finance but on which there is far from consensus. Theoretically, achieving it would mean maximizing the value of the company without putting it at risk of default and, at the same time, managing to optimally finance all its projects.

Javier Rivas, professor of finance at EAE Business School