Obiyathulla Ismath Bacha (TMR Media Sdn Bhd, 2018)
The capital structure decision is a highly important one for corporations. Capital structure refers to the combination of debt and equity (and other hybrids) that a company uses to fund itself. Going by finance theory, each corporation has its optimal capital structure. This optimal mix of debt and equity maximises the firm's market value by minimising its weighted average cost of capital. As debt is always cheaper than equity and has a tax shelter advantage, a firm's cost of capital reduces as it uses more debt in lieu of equity. However, risk increases as the proportion of debt increases. It is this trade-off between risk and return/value that gives rise to a minimal point for cost and a corresponding maximum for firm value. Thus, one firm's optimal debt-equity ratio may be 40/60 (40% debt and 60% equity) while another's 20/80 and so on.
