Overview
The capital structure of a firm refers to the manner in which the firm is funded. A firm needs capital (funds) in order to function. Initially, this is provided as start up capital by the founders and initial investors. As the firm grows, it is able to re-invest earnings back into the company.
At various times during its lifetime, a company may need additional funds in order to invest in machinery/equipment, or other projects it deems to be profitable. In order to obtain those funds, it goes to the Capital Markets, either by issuing debt or selling more equity shares of the company.
The choice of the appropriate mix of debt and equity, and the kinds of debt and equity chosen, is referred to as the capital structure of the firm.
The capital structure of the firm may impact its valuation as well as its risk structure and future oppurtunities.
Optimal Capital Structure
Optimal Capital Structure refers to idea that the capital structure can affect the valuation of a firm, and therefore, firms should seek to maximize valuation through the capital structure.