Target Capital Structure

The ultimate question for the financial manager is: What is the mix of debt on equity used to finance the income producing assets of my business which produces the lowest cost of capital ? The cost of capital is critical since the difference between the return produced by the assets of the business, and the overall cost of those assets, is the residual profit that increases the value of the shareholder interest. To put it another way, there is a combination of debt and equity in every company, which produces the lowest weighted average cost of the money which can be used to acquire new income producing capital assets, such as buildings and equipment. This combination is called the "target capital structure" since it is the goal of the financial manager to achieve and maintain it.

To understand this concept we visualize the right side of the balance sheet, "Liabilities" as a risk and cost ladder, with the lowest risk, lowest cost obligations on the top rung, and the highest risk, highest cost obligations at the bottom. Each of these items represent a percentage of the total amount at the bottom ,which must equal the sum of the "Assets" held by the company on the left side of the balance sheet. In addition, each of these items has a cost, except the items "accounts payable" and "accruals" which are free of explicit cost.

This "cost" increases for each item as the risk of that obligation increases. For example, the item "notes payable" which may represent bank obligations, and is high on the risk ladder might have a gross cost of 8% while the corporate bond item farther down the ladder might have a gross cost or 10%. These costs represent what the company has to pay to receive the money represented by the obligation since that obligation, because of its nature of duration, is a higher risk to the investor than one higher up the ladder. Thus, in many companies there is a substantial mix of obligations outstanding and used to finance the assets of the business, the overall cost of which is called the "cost of capital". Such a mix necessarily evolves from general economic conditions, dividend policies, short and long term interest rates, and other economic and company specific factors impacting the history of the company. Therefore, every company has a combination of obligations, at a mixed overall weighted cost, which has to be continually evaluated by the financial manager.

This evaluation starts with a determination of a target capital structure, that is, the establishment of an ideal arrangement of debt and equity, under current market conditions, which will produce the lowest possible overall cost of capital for assets which the company now has, but more particularly, for those which it will acquire as it attempts to grow its business. This ideal target structure, which could involve swapping bond obligations for stocks, for example, is an ongoing process geared to changes in market conditions and has as its goal the optimization of stock value.

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