"Optimal Capital Structure"

Knowing the company's capital structure is one of essential financial theory that required for both investor and company, its shows how much debt and equity a company currently posses. The combination of both cost of debt and cost of equity is normally known as weighted average cost of capital which allow funds managers to identify a hurdle rate that a fund manager must overcome before it can generate income and value to the company.

The allocation of the debt and equity for the company bring significant effect to the company value as the lower's of company wacc the higher the market value. In order to lower the wacc, one of the solution is to increase the cost of debt, meaning that the company is going to issue more debt to the investor, but with the higher debt  it might be causes a financial distress to the investor and lead to a fall of share prices and therefore lower the value of company. Hence, it is crucial for the fund manger to identify the optimum cost of capital or financing mix in order to generate greater value to company in the mean time not to lead any financial distress to investor.

Modigliani and Millar have came out with a alternate theory for the company's capital structure in 1958. Both of the claims that capital structure has no impact on the wacc and therefore no optimal structure exits. In Modigliani and Millar II, they amended their earlier model by recognizing the existence of corporate tax. Their they claim that the optimum capital structure for a company gearing is to be 100% of debt and therefore able to enjoyed the tax advantage. However, this is perhaps not applicable in practical due to the existing of bankruptcy cost, agency cost, tax exhaustion and etc etc. Undeniable, with the increase of debt capital it definitely will also enhance the default risk and the chances of not financial strong enough to pay back debt which lead to a bankruptcy. Looking into the largest bankruptcy in history Lehman Brothers with holding over $600 billion in assets, this is probably due to the inefficient of the capital structure with substantially high amount of debt.

After all, with the additional of debt, the benefit of tax deduction will be realized, but once it exceed the so called of  ''optimal capital structure " it will not create any advantage to the firm. In defining the optimal capital structure, i strongly believe that it is vary form different industry due to the ability of the constant cash flow from industry. For instance, the utility industry debt to equity ratio is definitely higher than the internet and social media industry due ability of generating cash in the industry.