According to Investopedia, the definition of optimal capital structure is the most beneficial mix of debt and equity financing, maximizing a company’s market value as well as minimizing cost of capital. Debt financing offers the lowest cost of capital due to its tax deductibility, but too much debt increases the financial risk to shareholders as well as and the return on equity. As such, companies must find the point at which the marginal benefit of debt equals the marginal cost of debt. Some economists state that in an efficient market, the value of a firm is not affected by its chosen capital structure.

Capital structure is the balance between equity and debt that a business uses to finance its assets, day-to-day operations, and future growth, therefore the decision on capital structure affects the machinery and fuel that make a company run, as well as its future direction.

Essentially it is an overview of all the claims on the business. Debt owners hold claims in the form of cash owed them with interest and equity owners hold claims in the form of access to a percentage of future profit. Capital structure is scrutinized when determining risks in investments and how expensive the financing should be.

A higher percentage of debt in the capital structure means increased fixed obligations. Increased fixed obligations means less operating buffer and greater risk which means higher financing costs.

Obtaining funding for a business with a debt-heavy capital structure is more expensive than getting that same funding when the business has an equity-heavy capital structure.

A financial manager must work with executive management to weigh and balance current costs, planned investments, growth plans, all types of projects (infrastructure, product and market position) and make decisions to optimize the mix.

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