It gives the Weighted Average Cost of Capital (WACC). If the firm needs to have the lowest WACC, it should design its capital structure in such a way that the debt equity ratio is high which would bring down the WACC.
The Optimal Capital Structure is that mix of debt and equity that maximizes the firm’s value or minimizes the cost of capital. There is no standard mix of debt and equity that maximizes the firm’s value, but each firm should strike a balance between risk and return thereby maximizing the share price, depending on its size and financial position.
1) If the firm size is small, it is difficult to make regular principal and interest payments in the event of shortages in generating substantial cash flow. Such firms face heavy fines and penalties by the creditors.
Trade-off Theory: Maximum debt can be raised when the share price is at its maximum. If the firm raises any more debt, the share price will decline. The point where share price is maximum, it is the trade-off point; risk and return are both at their peaks. Any change would cause a disbalance in the position of risk and return. The maximum risk involved is that of bankruptcy and the maximum return is the maximum value of the shares. Below is a graph that depicts the trade-off between risk and return.
Signaling Theory: This theory states that when the firm issues bonds for debt financing, it sends out a positive signal in the market. The cost of borrowing will be low as compared to the return the firm will get by putting money in that project.
When the firm issues shares for equity financing, it gives out a negative signal in the market because it reflects the credibility of the company and insinuates that the firm cannot raise finance by borrowing from the market and that it is in dire need of funds.
5) Future flexibility. The firm should leave room for maneuvering and have flexibility in the capital structure