Optimal capital structure

Theoretically, enterprises should try to maintain a certain optimal capital structure, a perfect mix of financing (debt and equity), which results in the lowest possible weighted average cost of capital. At this combination of debt and equity, the stock price is at the maximum. Therefore, attainment of the optimal structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. The optimal structure is also referred to as the target capital structure. However, it is important to note the optimal structure exists only in theory.

Theory does not yet offer a methodology that would allow firms’ financial managers to find the optimal capital structure. However, financial managers can determine the approximate optimal structure range, which is close to what they believe the optimal structure for the firm is.

As per above, an optimal structure maximizes the value of the firm. To find the value of the firm, we can use the following formula:

V=EBIT*(1-T)/ra

Which simplifies into:

V=NOPAT/ra

Where:

V = is the value of the firm

EBIT = is earnings before interest and taxes (see the income statement for how it is calculated)

NOPAT = is the net operating profit after taxes (calculated by formula EBIT*(1-T)/ra)

ra = is the weighted average cost of capital (WACC)

If we assume that NOPAT is consistent, then the value of the firm is affected by WACC (ra, weighted average cost of capital). WACC is affected by both, the cost of debt and equity.

The cost of equity

The cost of equity is higher than the cost of debt and increases as financial leverage increases. This is because equity suppliers will demand higher return for increasing financial risk due to increasing financial leverage.

The cost of debt

The cost of debt initially is relatively low. The major reason for this is due to the fact that interest on debt is tax deductible. This tax deductibility of interest paid on debt is also commonly called the tax shield. However, as debt increases, at certain debt ratio lenders will begin to require higher and higher interest payments from the borrower. This is undertaken in order to compensate for increasing risk due to increasing financial leverage.

There are two other costs of debt that the firm needs to consider:

(1) Debt increases the probability of bankruptcy. This is because lenders can force the firm into bankruptcy if the firm cannot meet its financial obligations to the lender.

(2) Another aspect to consider is the agency cost. This refers to the fact that lenders usually protect themselves from increases in risk of the borrower by imposing different loan provisions, which place constraints on actions and choices of the firm. Such provisions commonly include, but are not limited to, minimum levels of liquidity to be maintained, limits on compensation of the executives and limitations on asset acquisitions.

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As debt increases from a zero point onwards, WACC initially decreases to the theoretical optimal capital structure point. Thereafter, the increasing equity cost and increasing cost of debt causes WACC to start increasing again. Therefore the theoretical optimal capital structure is obtained at the point where the WACC is the lowest.

In other words, the theoretical optimal capital structure occurs at the point where the benefits from using debts are in equilibrium (in balance) with the costs of using debt. The optimal capital structure can also be seen as the balance between risk and return where the firm’s stock price is maximized.

Capital structure decisions

Capital structure decisions refer to the decisions businesses have to make with regards to the mix of financing they use. The mix consists of debt and/or equity as sources of capital. In other words, it is a structure of the liabilities and equity side of the balance sheet, excluding current liabilities. Enterprises usually try to maintain a certain optimal mix of financing (debt and equity), referred to as the target capital structure.

The modern approach to capital structures is largely influenced by the work of Franco Modigliani and Merton H. Miller. This is also known as the M and M, or MM work. Their work published in 1958 in American Economic Review (June 1958) entitled “The Cost of Capital, Corporation Finance, and the Theory of Investment” suggests that under condition of perfect markets, capital structure decisions do not affect the value of the firm. Any increase in Return on Equity goes hand in hand with increase in risk. Therefore, weighted average cost of capital (WACC) stays constant.

In their later work, Franco Modigliani and Merton H. Miller introduced taxes into the model. Their further conclusion was that if corporate taxes are present then the value of the enterprise will increase continuously as more debt is added to capital structure.

This is possible because debt interest payments are tax deductible. However, it is evident that personal taxes will decrease the advantage gained. As a result, it is still profitable to use debt financing. However, the advantage gained is lessened by the existence of personal taxes versus existence of just corporate taxes.

Theoretically, enterprises can increase the value of the firm by finding the optimum capital structure (mix of equity and debt). The optimum capital structure refers to capital structure decisions according to which the weighted average cost of capital is at its minimum value and, as a result, the value of the firm is maximized.

Therefore, the optimum capital structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. However, it is important to note that the optimal capital structure exists only in theory.

Sources of capital

Sources of capital include debt and equity. Equity is further subdivided into preferred stock and common stock. In turn, common stock is even further subdivided into new common stock and retained earnings.

When making capital structure decisions, it is important to keep in mind that generally debt is the least expensive source of capital. This is due to the fact that the lender takes much less risk than suppliers of the equity capital. This is occurs because:

(1) Debt has obligatory scheduled payments. Whereas, equity suppliers, especially in case of common stock, will only be paid when company can afford to do so.

(2) In case of liquidation, lenders have priority claim on assets of the company over equity suppliers.

(3) If firm misses obligatory interest or principal payments, lenders can force the firm into bankruptcy. Therefore, lenders have more power in ensuring that payments will be made on time.

Moreover, interest on debt is tax deductible, which makes it an even cheaper source of capital for the firm. Overall, and as stated above, debt is generally the cheapest source of capital for the firm.

How capital structure decisions affect the risk of a company?

Enterprises deal with three types of risks: financial risk, business risk and total risk. The capital structure directly affects the financial and total risk of the firm.

FINANCIAL RISK – a chance that firm will not be able to meet its financial obligations, which can result in bankruptcy. Financial risk is directly affected by the firm’s capital structure (its mix of debt and equity financing). The more debt the firm uses in its capital structure mix, the higher the financial risk.

BUSINESS RISK – a chance that firm will not be able to cover its operating costs. There are three factors that affect business risk. These are an increase in the degree of operating leverage, revenue instability and cost instability. Capital structure decisions do not affect business risk.

TOTAL RISK – a combination of financial and business risk. Since capital structure decisions affect financial risk, the total risk is also affected.

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