Reviewed by Athena Updated on Nov 11, The optimal capital structure of a company refers to the proportion in which it structures its equity and debt. It is designed to maintain the perfect balance between maximising the wealth and worth of the company and minimising its cost of capital.
The objective of a company is to determine the lowest weighted average cost of capital WACC while deciding on its capital structure.
The WACC is the weighted average of its cost of equity and debt. It is not mandatory for a company to take any debt. A company can have a capital structure that is all-equity, or a structure with minimal debt. It also depends on the industry the company belongs to because standard capital structures vary from industry to industry and whether the company is a private or public company.
Maximise the company's wealth An optimal capital structure will maximise the company's net worth, wealth, and market value. The wealth of the company is calculated in terms of the present value of future cash flows. This is discounted by the WACC. Minimise the cost of capital The lower the cost of the capital, the lower is the risk of insolvency. In , Modigliani and Miller stated that, assuming a perfect capital market and ignoring taxation, the WACC remains constant at all levels of gearing.
As a company gears up, the decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset by the increase in the WACC caused by the increase in the cost of equity due to financial risk. The WACC remains constant at all levels of gearing thus the market value of the company is also constant.
The cost of equity is directly linked to the level of gearing. As gearing increases, the financial risk to shareholders increases, therefore Keg increases. The WACC, the total value of the company and shareholder wealth are constant and unaffected by gearing levels. No optimal capital structure exists. In , when Modigliani and Miller admitted corporate tax into their analysis, their conclusion altered dramatically.
As debt became even cheaper due to the tax relief on interest payments , cost of debt falls significantly from Kd to Kd 1-t. Thus, WACC falls as gearing increases. Companies should therefore borrow as much as possible.
Optimal capital structure is Companies are discouraged from following this recommended approach because of the existence of factors like bankruptcy costs, agency costs and tax exhaustion. All factors which Modigliani and Miller failed to take in account. Modigliani and Miller assumed perfect capital markets; therefore, a company would always be able to raise funding and avoid bankruptcy.
In the real world, a major disadvantage of a company taking on high levels of debt is that there is a significant possibility of the company defaulting on its increased interest payments and hence being declared bankrupt. If shareholders and debt-holders become concerned about the possibility of bankruptcy risk, they will need to be compensated for this additional risk. Therefore, the cost of equity and the cost of debt will increase, WACC will increase and the share price reduces.
If this with-tax model is modified to take into account the existence of bankruptcy risks at high levels of gearing, then an optimal capital structure emerges which is considerably below the In most large companies, the finance providers principals are not able to actively manage the company. Therefore, the management may make decisions that benefit the shareholders at the expense of the debt-holders.
This action could potentially benefit shareholders as they may benefit from the higher returns, but the debt-holders would not get a share of the higher returns since their returns are not dependent on company performance.
Thus, the debt-holders do not receive a return which compensates them for the level of risk. These restrictive covenants may limit how much further debt can be raised, set a target gearing ratio, set a target current ratio, restrict the payment of excessive dividends, restrict the disposal of major assets or restrict the type of activity the company may engage in. As gearing increases, debt-holders would want to impose more constrains on the management to safeguard their increased investment.
Management do not like restrictions placed on their freedom of action. Thus, they generally limit the level of gearing to limit the level of restrictions imposed on them.
The fact that interest is tax-deductible means that as a company gears up, it generally reduces its tax bill. The tax relief on interest is called the tax shield — because as a company gears up, paying more interest, it shields more of its profits from corporate tax. The tax advantage enjoyed by debt over equity means that a company can reduce its WACC and increases its value by substituting debt for equity, providing that interest payments remain tax deductible.
However, as a company gears up, interest payments rise, and reach a point that they are equal to the profits from which they are to be deducted; therefore, any additional interest payments beyond this point will not receive any tax relief. This is the point where companies become tax - exhausted, ie interest payments are no longer tax deductible, as additional interest payments exceed profits and the cost of debt rises significantly from Kd 1-t to Kd.
Once this point is reached, debt loses its tax advantage and a company may restrict its level of gearing. The WACC will initially fall, because the benefits of having a greater amount of cheaper debt outweigh the increase in cost of equity due to increasing financial risk. The WACC will continue to fall until it reaches its minimum value, ie the optimal capital structure represented by the point X. At very high levels of gearing, bankruptcy risk causes the cost of equity curve to rise at a steeper rate and also causes the cost of debt to start to rise.
The cost of debt is less expensive than equity because it is less risky. The required return needed to compensate debt investors is less than the required return needed to compensate equity investors, because interest payments have priority over dividends, and debt holders receive priority in the event of a liquidation.
Debt is also cheaper than equity because companies get tax relief on interest, while dividend payments are paid out of after-tax income. However, there is a limit to the amount of debt a company should have because an excessive amount of debt increases interest payments, the volatility of earnings, and the risk of bankruptcy.
This increase in the financial risk to shareholders means that they will require a greater return to compensate them, which increases the WACC—and lowers the market value of a business. Companies with consistent cash flows can tolerate a much larger debt load and will have a much higher percentage of debt in their optimal capital structure. Conversely, a company with volatile cash flows will have little debt and a large amount of equity. As it can be difficult to pinpoint the optimal capital structure, managers usually attempt to operate within a range of values.
They also have to take into account the signals their financing decisions send to the market. A company with good prospects will try to raise capital using debt rather than equity, to avoid dilution and sending any negative signals to the market. Announcements made about a company taking debt are typically seen as positive news, which is known as debt signaling. If a company raises too much capital during a given time period, the costs of debt, preferred stock, and common equity will begin to rise, and as this occurs, the marginal cost of capital will also rise.
They also compare the amount of leverage other businesses in the same industry are using—on the assumption that these companies are operating with an optimal capital structure—to see if the company is employing an unusual amount of debt within its capital structure.
Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the company into a credit profile using a bond rating. The default spread attached to the bond rating can then be used for the spread above the risk-free rate of a AAA-rated company. Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure.
What defines a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm's stage of development, and can also vary over time due to external changes in interest rates and regulatory environment.
However, because investors are better off putting their money into companies with strong balance sheets, it makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity.
Modigliani and Miller were two economics professors who studied capital structure theory and collaborated to develop the capital structure irrelevance proposition in This proposition states that in perfect markets the capital structure a company uses doesn't matter because the market value of a firm is determined by its earning power and the risk of its underlying assets.
According to Modigliani and Miller, value is independent of the method of financing used and a company's investments. This proposition says that the capital structure is irrelevant to the value of a firm.
The value of two identical firms would remain the same and value would not be affected by the choice of financing adopted to finance the assets.
The value of a firm is dependent on the expected future earnings. It is when there are no taxes. This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.
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