Understanding Capital Structure: Part 2

In Part 1 of this blog series, we outlined the two components of capital structure – debt and equity – as well as the advantages and disadvantages of both. While it is fundamental to understand the two separate components, it is just as important to understand how they work together to make up an optimal capital structure.

What is Optimal Capital Structure

As mentioned in Part 1, there are many advantages and disadvantages associated with debt and equity financing, and finding the perfect mix of both is often sought after to ensure your company can capitalize on the advantages of both sources. The optimal capital structure is a company’s unique combination of debt and equity that results in the lowest weighted average cost of capital (WACC).

As we know from our blog “What is WACC?”, WACC is calculated as the weighted average cost of the debt and equity a company has used to finance their operations:

WACC represents the average rate of return that the debt and equity holders receive in exchange for their capital funding.

How is an Appropriate Capital Structure Determined?

Determining a company’s optimal capital structure is a complex exercise given the array of factors that are involved. Factors that impact a company’s capital structure include industry characteristics, economic conditions, existing leverage and share ownership, growth opportunities, risk levels, profitability, regulatory environment, and whether the company is public or private.

When valuing a company, CBVs often assume a notional purchaser would establish an appropriate capital structure in a notional acquisition. To determine the appropriate capital structure to use in determining WACC, they look towards the debt and equity weightings of companies within comparable industries with additional consideration given to the company’s specific debt capacity.

How Does Capital Structure Impact Valuations?

Since capital structure is the mixed weighting of debt and equity, it directly affects the WACC calculation and the company’s level of risk. Given the inverse of WACC, minus the anticipated long term growth rate, is equal to the multiple at which a company is capitalized, capital structure plays a significant role in how a company is valued. This is why CBVs strive for an appropriate capital structure when valuing a company.

As discussed, the theory behind optimal capital structure can be difficult to apply in real world scenarios but determining an appropriate capital structure is a key part of the valuation process and requires a high level of professional judgement.

If you would like a further discussion on capital structure or your company’s specific situation, please do not hesitate to call our team.

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