Optimal Capital Structure

Debt is usually cheaper than equity, because lenders take less risk than shareholders and, in many countries, interest is tax-deductible. Adding some debt can therefore lower a company's weighted average cost of capital. But as debt rises, so does the risk of financial distress and bankruptcy, which pushes up the cost of both debt and equity.

The optimal capital structure is the point where the benefits of extra debt are balanced by these extra costs. Beyond it, more borrowing destroys value.

For example, a stable utility with predictable cash flows might support a high proportion of debt, while a young technology company with volatile earnings and few tangible assets might rely mostly on equity.

In practice, there is no precise formula. Companies consider factors such as the stability of their cash flows, their assets, tax position, industry norms, credit rating targets and the flexibility to fund future opportunities. Theories such as the trade-off theory and the pecking order theory offer different explanations of how companies actually choose their mix.