1. Optimal Capital Structure
So here we want to discuss capital structure, which refers to the amount
of debt and/or equity that a firm uses in order to fund its
operations and finance its assets. And then in order to optimize the capital
structure, the firm would then decide if it needs to issue more debt
or more equity. We can also talk about the idea of leverage,
and here's an example with low leverage, which refers to the amount of
debt which has been used in the capital structure, which is only about
20%. An example on the right hand side would be high leverage,
in this case, we're using 80% debt in the capital structure.
So leverage really refers to the amount of debt used in the capital
structure. So let's now continue this discussion of the optimal capital
structure, it's essentially a discussion about the amount of equity versus
the amount of debt, and it relies on a large number of factors.
The current economic climate, it could be the business' existing capital
structure, or the life cycle stage that the business is at. Now,
earlier we discussed some pros and cons of using debt and equity in
the capital structure. For instance, having too much debt can obviously
increase the risk of the default in one of the repayments,
on the other hand, depending too heavily on equity, may dilute earnings
and value for the original shareholders. Now, let's dig a little bit deeper
into the optimal capital structure, and effectively companies are looking
for the optimal combination of debt and equity in order to minimize the
cost of capital. If we're being more specific, the optimal capital structure
actually occurs at the minimum of what we call the weighted average cost
of capital or the WACC. So let's now bring in a chart to
really illustrate this point. On the vertical axis, we have the weighted
average cost of capital or the WACC and at the bottom,
we have the debt to total capital or the leverage. If we bring
in this curve, we can see that a company, if the company used
too little debt, then it would have a relatively high WACC, because it's
using too much equity. On the other end of the spectrum,
if the company was using an excessive amount of debt, then the interest
cost would likely be high, and it would also have a high weighted
average cost of capital. So right in the middle, at point B,
we have a sweet spot where the company has optimized the capital structure,
ie, it has flexed the amount of debt and equity to the point
where it's reached the minimum weighted average cost of capital or WACC.
2. Let's practice!