Answer:
The optimal capital structure is the best debt-to-equity ratio that maximizes the value of a business. The optimal capital structure of a company helps a business choose the best debt-to-equity range, thus bringing down its cost of capital to a minimum.
The target capital structure is a result achieved when debt, preferred stock, and common stock are mixed in such a way that the mix maximizes the stock price of the business. This capital structure decides the amount of borrowing, types of debt, and stockholder contributions.
Various factors affect the target capital structure.
Business risk: As business risk increases, debt ratio increases. High-risk ventures will be better off if they choose equity financing because it opens up a wide variety of choices to deal with various situations.
Taxes: If taxable income increases, debt increases, too. Debt costs are tax deductible. So a highly taxed company can use debt to finance a project in order to protect income from taxes.
Financial flexibility: A financially flexible company can take better advantage of market conditions. When the company is growing, getting funds is easier. Lower debt means better financial flexibility.
Management style: Conservative managers use less debt. Aggressive managers may want quick growth and depend more on debt to increase profits.
Cost of funds: The cost of equity financing is the expected annual profitability rate. If the company does not provide this rate, investors may withdraw their investments.
Business cycle: In the growth stage, businesses opt for debt financing, regardless of the potential instability of the arrangement. Stable firms opt for less debt.
Market conditions: During an economic downturn, interest rates may go up because the availability of funds is restricted. Companies wait for better market conditions before trying to raise capital.
Explanation:
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