1. Creating optimal capital structure by determining the most optimal proportion of equity and borrowed financing in the capital structure, is very essential process of financial management. Companies have to find the best combination that maximizes its' market value.
The optimal capital structure that is, the ideal ratio of long-term debt to total capital is hard to estimate. It depends on various factors:
First, optimal capital structure varies by industry, mainly because some industries are more asset-intensive than others. In very general terms, the greater the investment in fixed assets (plant, property, & equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Industries that require a great deal of plant investment, such as telecommunications, generally utilize more long-term debt.
Second, capital structure tends to track with the company's growth cycle. Rapidly growing startups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments--as these companies are growth stocks--in favor of future price returns. High-growth companies do not need to give these shareholders cash today, whereas lenders would expect semi-annual or quarterly interest payments.
Knowledge intensive companies show low levels of debt and are funded primarily by equity, because their intangible assets (like R&D) are highly volatile and cannot easily be valued.
Firms in high-knowledge sectors make less use of debt and greater use of internal accruals than those in low-knowledge sectors. This is consistent with the general proposition that firms operating in more uncertain domains may face greater barriers ...