An optimal capital structure can be achieved once the market value of the firm is

maximized through an appropriate mix of equity and debt finance used by the company to

finance assets. This mixture of equity and debt finance is determined by financing decisions

that directly affect the weighted average cost of capital (WACC). WACC is the weighted

average cost of equity and cost of debt, any changes in the proportions of said variables will

result changing the WACC. Simply, the lower the WACC, the more optimal the capital

structure becomes.

To have the lowest WACC, two contradicting points have to be achieved. Issuing more

debt to replace expensive equity, which reduces WACC, and at the same time, as more debt

has occurred, it increases the WACC through gearing, financial risk, and the beta equity

involved.

According to Modigliani and Miller in 1958, assuming a perfect capital market and

ignoring taxation, the WACC remains constant at all gearing levels. As a company gears up,

the decrease of WACC caused by greater amount of cheaper debt is exactly offset by the

increase of WACC caused by increase in cost of equity due to financial risk. Therefore, no

optimal capital structure exists.

Reference:

https://www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-exams-stu

dy-resources/f9/technical-articles/optimum-capital-structure.html