What is the 'Optimal Capital Structure' companies aim to achieve?

One of the key components of corporate finance nowadays is finding the right mix of debt and equity which is used in order to fund a business. Different companies will have different methods of financing their operations, some may even solely rely on debt or equity whilst others will try find the perfect mix. 'Capital Structure' is defined by Arnold (2013) as the proportion of a company's capital which is debt or equity, but what does this mean?. Capital Structure uses the Weighted Average Cost of Capital (WACC) in order to calculate the average return for a company based on how much debt and equity they hold. This calculation suggests a possible optimal structure. The lower the company's debt and gearing level, the higher the WACC and return for investors. As the gearing level begins to increase, the overall cost of finance decreases , but with it brings the risk of the company becoming financially distressed!

But if debt is a lower cost than equity, it should suggest that companies should just take on more debt rather than equity does it not??? Why is debt generally cheaper than equity? This is down to debt interest being a tax deductible expense which generates tax benefits in most countries, and this is something that dividends are not. The issuing and transaction costs involved with debt are also much lower than that for ordinary shares as-well! On the down side, debt increases the possibility of financial distress due to all its potential costs, which can ultimately lead to bankruptcy!


Back in 1958, two men called Modigliani and Miller devised a theory which argued that companies capital structure has NO impact on the WACC,  NO optimal structure exists and that the companies value depends solely on business risk!! M&M put forward the following 5 assumptions:


1. There is no taxation
2. There are perfect capital markets
3. There are no costs of financial distress and liquidation
4. Firms can be classified into distinct risk classes
5. Individuals can borrow as cheaply as operations






From my current understanding of the topic, I completely disagree with them as you simply cannot ignore taxation when it comes to capital structure!! I think we all know by now as-well that perfect capital markets don't exist in real life and so this was yet another flaw that M&M would come to realise in 5 years time when they had to revise their paper. The 1963 paper proposes that the more in debt a company is the more shareholders will gain although one of the main points to address is that the WACC falls as the gearing rises meaning the company value will increase.


Lehman Brothers is a great example of a company that ended up filing for bankruptcy due to significant debt they racked up, otherwise known as gearing. Its leverage ratio was posing a high risk to the company at 31:1 in 2007. Yes, this may have generated huge profits during the boom, but it left them very vulnerable to extreme risk. I believe that this ratio was very inaccurate and left them susceptible to any downfall. Companies need to ensure they maintain a manageable weighted cost of capital to achieve an optimal capital structure. Both debt and equity obligations should be paid in a timely fashion and that the costs of financing don't ultimately bankrupt the company. My solution is that a firm should choose a range for the optimal; around 20-40% optimal debt ratio in order to maintain financially stable. What do you think? Let me know below!