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# Optimal Capital Structure and Average Firm in Industry

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1. In practice, how can a firm determine whether it is operating at (or near) its optimal capital structure?

2. Under what circumstances should a firm use:
a) more debt in its capital structure than is used by the "average" firm in the industry?
b) when should it use less debt than the "average" firm?

#### Solution Preview

Capital structure

1. In practice, how can a firm determine whether it is operating at (or near) its optimal capital structure?
To begin it is important to understand what optimal or optimum capital structure is in financial management. An optimal capital structure is more or less a capital structure that creates a balance between the risk and return. Optimal capital structure also capitalizes on the price of the stock while at the same time minimizing the cost of capital. In other words, optimal capital structure is the best debt/equity ratio for a specific company. This debt/equity ratio previously spoken of will ultimately minimize the cost of capital (e.g. the cost of financing the company's operations). When a company minimizes this cost of capital they will ultimately maximize the value of their company. The good thing about knowing the optimal capital structure for a company is for the fact that once determined it does not affect the company if deviated from in small portions.
So back to your question. How can a firm determine whether it is operating at or near its optimal capital. In order for a firm to determine whether it is operating at or near its optimal capital is by that firm taking its overall capital and weighing the average of the cost of their debt and the cost of their equity. For example, let's use Wal-Mart. Let's say Wal-Mart's debt/equity ratio is 30/70 and the after-tax cost of debt is 4% and the cost of equity is 10.5%. So let's get Wal-Marts overall cost of capital: I would take debt ratio (0.30), multiply that by their after-tax cost of debt (4%) and add their equity ...