A company’s capital structure refers to the combination of its various sources of funding. Most companies are funded by a mix of debt and equity, including some short-term debt, some long-term debt, a number of shares of common stock, and perhaps shares of preferred stock.
When determining a company’s cost of capital, weight the costs of each component of the capital structure in relation to the overall total amount. This calculates the company’s weighted average cost of capital (WACC). Then use the weighted average cost of capital to calculate the net present value (NPV) of capital budgeting for corporate projects. A lower WACC will yield a higher NPV, so achieving a lower WACC is always optimal. Refer to overseeing the capital structure as capital structure management.
Under stable market conditions, a company can compute its optimal mix of capital. A company’s optimal mix of capital is the combination of sources of capital that yields the lowest weighted average cost of capital.
For example, if a company is financed by a combination of low-cost debt and higher-cost equity, then the optimal mix of capital would be some combination involving less of the higher-cost equity and more of the low-cost debt. In conclusion, you can employ capital structure policy and capital structure strategy to achieve the optimal capital mix.
Let’s say, for example, a company could raise between 40% and 60% of its needed funds with debt costing 8%. It could raise up to 10% of its needed funds with preferred stock issuance that costs 7.8%. Then it can raise between 30% and 50% of its funds by issuing common stock equity at 12.33%. What capital structure policy should the company employ to achieve its optimal capital mix?
After analyzing the numbers, and due to certain limitations and restrictions outside the scope of this simple example, the company came up with three choices:
Debt Preferred Stock Common Stock WACC Mix 1: 40% 10% 50% 10.145% Mix 2: 59% 10% 31% 9.322% Mix 3: 60% 10% 30% 11.679%
As you can see, the company would be better off choosing Mix 2, which has the lowest WACC: 9.322%.