Optimal Capital Structure Essay

The optimal groovy coordinate for a political party should be the mix of loveliness, debt and hybrid instruments that minimizes the overall cost of supporting, i.e. it should minimize the clubs weighted average cost of slap-up letter. In practice, however, it is not doable to specify this optimal capital structure exactly, for any individual corporation. It clearly makes sense to obtain funds at the lowest possible cost. In the long run, debt is cheaper than equity. However, when a companys financial leverage increases as it pees on more debt capital, there is an increasing risk for stockholders. The cost of equity therefore will rise, perhaps offsetting the benefits of raising cheap debt capital. Although management cannot be specific about the optimal capital structure for their company, they should at least(prenominal) be aware ofhow banks and the capital markets might respond to an increase in the companys leverage level if it were to borrow brand-new funds, and Whe ther the company is sufficiently low geared to make new debt capital an pleasant option, compared to a new issue of equity as a fund-raising measure. on that point are two approaches to managing a companys capital structure a reactive and a proactive approach. The reactive approach is to take accompaniment decisions when a requirement for moreor lessfunding becomes apparent, and to raise or skip capital by the method that seems topper at the time. The proactive approach that is found in companies with large and well-organized treasury functions is toforecast future funding requirements or funding surpluses as very much as possible establish channelizes for capital structure, in particular a target leverage level (a target range) and a target maturity date profile for debt capital If appropriate, raise funds early when new funding requirements are anticipated, in order to take advantage of favorable conditions in the capital markets or low bank lending rates.This approach call s for immaculate and flexible forecasting skills, and good treasury management systems. A proactive approach also can be taken to reducing funds, whenever a company considers its current funding to be in excess of requirements for the foreseeable, long-run future. By having a target leverage level and a target debt maturity profile, management can decide which method of removing surplus capital might be more appropriate, i.e.reducing equity, by raising dividends or buying back and canceling stocks, or Redeeming loans early.Companys capital structure is never static and will change over time. retain honorarium that should be earned continually add to equity and reduce leverage levels. It is not unusual, therefore, for companies to experience funding cycles of high leverage, as new loans are obtained to fund capital expansion, and decreasing leverage, as retained earnings are earned. The cash flows generated from profits could be used to redeem loans and thereby replace debt capit al with equity in the companys capital structure.