Therefore, according to the NOI approach, there cannot be any optimum capital structure for a firm. The Net Income NI approach to an optimal capital structure states that the total value of the firm changes with a change in the financial leverage. At very high levels of gearing, bankruptcy risk causes the cost of equity curve to rise at a steeper rate and also causes the cost of debt to start to rise.
Conversely, a company with volatile cash flow will have little debt and a large amount of equity. Limitations to Optimal Capital Structure Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. Therefore an issue of equity by a company is interpreted as a sign the management believe that the shares are overvalued.
Companies with consistent cash flows can tolerate a much larger debt load and will have a much higher percentage of debt in their optimal capital structure. The cost of equity is directly linked to the level of gearing. Equity is the ownership interest in a firm including equity share capital, share premium, preference share capital, free reserves, and surplus profits.
However, as a company gears up, interest payments rise, and reach a point that they are equal to the profits from which they are to be deducted; therefore, any additional interest payments beyond this point will not receive any tax relief.
Debt comes in many forms: leasing, factoring, mortgages, second mortgages, senior debt, subordinated debt, revolving loans, demand loans, etc. In practical terms, this can be achieved by having some debt in the capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing WACC can be decreased further or too much gearing the company suffers from bankruptcy costs, agency costs and tax exhaustion.
In an efficient market, the value of a firm is unaffected by its capital structure. In simple terms, the composition of the total capital of a company constitutes its capital structure.