Final answer:
The optimal capital structure maximizes the earnings per share by balancing the cost of debt and equity to minimize the overall cost of capital, all while managing financial risk and encouraging investment.
Step-by-step explanation:
An optimal capital structure is a financial mix that a firm aims to maintain in order to maximize the earnings per share (EPS). This structure is the result of the balance between debt and equity financing that minimizes the firm's cost of capital. Achieving the optimal capital structure allows a firm to ensure it is maximizing shareholder value.
Finding this balance involves trade-offs, as too much debt can increase the risk of bankruptcy, while too much equity can dilute the earnings among a larger pool of shareholders. The cost of capital is crucial in this optimization process as it represents the hurdle rate that investments must overcome to be profitable. Therefore, the firm must carefully consider its debt levels to maintain a cost of capital that encourages investment and maximizes return on equity.
Growth opportunities, industry standards, and market conditions are also essential considerations when assessing the optimal capital structure. The aim is to sustain growth and profitability without incurring excessive financial risk.