Which of the following is not a feature of optimal capital structure ?

The correct answer is - Option 1: The company should make maximum use of leverage at a minimum cost

Key Points

• Optimal capital structure refers to the mix of debt and equity financing that minimizes the cost of capital while maximizing shareholder value.
• Leverage should be used carefully to avoid excessive financial risk. Making "maximum use of leverage" contradicts the principle of maintaining balance in the capital structure.
• Optimal capital structure seeks to strike a balance between risk and return, ensuring the company does not become over-leveraged.
• Excessive reliance on leverage can lead to financial distress, increased fixed obligations, and vulnerability during economic downturns.
• Therefore, the correct approach is to use leverage judiciously, not maximally, while keeping the cost of capital low.

Additional Information

• Key features of an optimal capital structure:
  • Flexibility: The capital structure should allow the company to adapt to changing economic conditions or business needs.
  • Control: It should minimize dilution of ownership and voting power for existing shareholders.
  • Risk: The structure should balance financial and business risks to ensure long-term sustainability.
  • Cost-effectiveness: The structure should aim to minimize the weighted average cost of capital (WACC).
• Leverage:
  • Leverage refers to the use of debt to finance operations or growth. While it can amplify returns, it also increases financial risk.
  • Optimal leverage is determined by factors such as industry norms, business stability, and interest rate conditions.
• Trade-off theory:
  • The theory suggests companies balance the tax benefits of debt (interest deductibility) against the risk of financial distress.
  • Over-leveraging increases the risk of bankruptcy and operational inefficiency.