Meaning of Optimal capital structure
The capital structure is said to be optimum, when the company has selected such a combination of equity and debt, so that the company's wealth is maximum. At this, capital structure, the cost of capital is minimum and market price per share is maximum. But, it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. In reality, however, instead of optimum, an appropriate capital structure is more realistic.
Features of an appropriate capital structure are as below:
1) Profitability: The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share.
2) Flexibility: The capitals structure should be such that the company is able to raise funds whenever needed.
3) Conservation: Debt content in capital structure should not exceed the limit which the company can bear.
4) Solvency: Capital structure should be such that the business does not run the risk of insolvency.
5) Control: Capital structure should be devised in such a manner that it involves minimum risk of loss of control over the company.
Importance of Optimal Capital Structure
a) Minimized Cost: The primary objective of a company is to maximize the shareholder’s wealth through minimization of cost. A well-advised capital structure enables a company to raise the requisite funds from various sources at the lowest possible cost in terms of market rate of interest, earning rate expected by prospective investors, expense of issue etc. this maximize the return to the equity shareholders as well as the market value of shares held by them.
b) Maximized Return: The primary objective of every corporation is to promote the shareholders interest. A balanced capital structure enables company to provide maximum return to the equity shareholders of the company by raising the requesting capital funds at the minimum cost.
c) Minimize Risks: A sound capital structure serves as an insurance against various business risks, such as interest in costs, interest rates, taxes and reduction in prices. These risks are minimized by making suitable adjustments in the components of capital structure. A balanced capital structure enables the company to meet the business risks by employing its retained earning for the smooth business operations.
d) Controlled: Though the management of a company is apparently in the hands of the directors, indirectly, a company is controlled by equity shareholders carry limited voting rights and debentures holders do not have any voting right, a well-devised capital structure ensures the retention of control over the affairs of the company with in the hands of the existing equity shareholders by maintaining a proper balance between voting right and non-moving right capital.
e) Liquid: An object of a balanced capital structure is to maintain proper liquidity which is necessary for the solvency of the company. A sound capital structure enables a company to maintain a proper balance between fixed and liquid assets and avoid the various financial and managerial difficulties.
f) Optimum Utilization – Optimum utilization of the available financial resources is an important objective of a balanced financial structure. An ideal financial structure enables the company to make full utilization of available capital by establishing a proper co-ordination between the quantum of capital and the financial requirements of the business. A balanced capital structure helps a company to estimate both the states of over-capitalization and under-capitalization which are harmful to financial interests of the company.
g) Simple: A balanced capital structure is aimed at limiting the number of issues and types of securities, thus, making the capital structure as simple as possible.
h) Flexible: Flexibility or capital structure enables the company to raise additional capital at the time of need, or redeem the surplus capital. it not only helps is fuller utilization of the available capital but also eliminates the two undesirable states of over-capitalization and under – capitalization.