The Firm's Target Capital Structure

E

The target capital structure is the mix of debt, preferred stock, and common equity with which the firm plans to raise capital.

The firm's target capital structure refers to the optimal combination of debt and equity that a company aims to maintain in order to finance its operations and maximize shareholder value. It is important for a company to determine its target capital structure as it impacts the cost of capital and the overall risk profile of the firm.

Let's analyze each option provided:

A. Minimum cost of equity: The cost of equity represents the return required by shareholders to invest in the company's stock. While minimizing the cost of equity is important, it is not necessarily the primary consideration when establishing the target capital structure. The cost of equity is influenced by factors such as the risk-free rate, the company's beta, and the equity risk premium. Therefore, the firm's target capital structure is not solely focused on minimizing the cost of equity.

B. Maximum earnings per share (EPS): Maximizing earnings per share is a financial objective that relates to profitability and shareholder value. However, the target capital structure is not directly related to this objective. The capital structure primarily focuses on determining the appropriate mix of debt and equity to optimize the firm's overall cost of capital and risk level.

C. Minimum cost of debt: The cost of debt refers to the interest rate or other costs associated with borrowing funds. While minimizing the cost of debt is desirable, it is not the sole determinant of the target capital structure. The firm needs to balance the cost of debt with other factors such as the availability of debt financing, debt capacity, and the impact on the overall risk profile of the company.

D. Minimum risk: Minimizing risk is an important consideration in establishing the target capital structure. However, the firm's target capital structure is not solely focused on minimizing risk. The target capital structure needs to strike a balance between risk and return, considering the risk tolerance of the firm, industry norms, and the cost of capital.

E. Minimum weighted average cost of capital (WACC): The weighted average cost of capital (WACC) represents the average cost of financing for a company, taking into account the proportion of debt and equity in the capital structure. The WACC is a key consideration in determining the target capital structure. The firm aims to minimize the WACC as it represents the overall cost of capital and is used to evaluate the feasibility of investment projects. By minimizing the WACC, the company can maximize its value. Therefore, the target capital structure is consistent with minimizing the weighted average cost of capital (WACC).

In conclusion, among the given options, the firm's target capital structure is consistent with minimizing the weighted average cost of capital (WACC) (Option E). While other factors such as minimizing the cost of equity, cost of debt, and risk are also considered, the WACC is a comprehensive measure that accounts for both the cost and proportion of debt and equity in the capital structure.