The Target Capital Structure

Firms can choose whatever mix of debt and equity they desire to finance their assets, subject to the willingness of investors to provide such funds. And, as we shall see, there exist many different mixes of debt and equity, or capital structures - in some firms, such as Chrysler Corporation, debt accounts for more than 70 percent of the financing, while other firms, such as Microsoft, have little or no debt.

In the next few sections, we discuss factors that affect a firm's capital structure, and we conclude a firm should attempt to determine what its optimal, or best, mix of financing should be. But, you will find that determining the exact optimal capital structure is not a science, so after analyzing a number of factors, a firm establishes a target capital structure it believes is optimal, which is then used as a guide for raising funds in the future. This target might change over time as conditions vary, but at any given moment the firm's management has a specific capital structure in mind, and individual financing decisions should be consistent with this target. If the actual proportion of debt is below the target level, new funds will probably be raised by issuing debt, whereas if the proportion of debt is above the target, stock will probably be sold to bring the firm back in line with the target debt/assets ratio.

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