Optimal Capital Structure

What Is Optimal Capital Structure?

The optimal capital structure of a firm is the best mix of debt and equity financing that boosts a company's market value while limiting its cost of capital. In theory, debt financing offers the most reduced cost of capital due to its tax deductibility. Notwithstanding, too much debt increases the financial risk to shareholders and the return on equity that they require. Subsequently, companies need to find the optimal place where the marginal benefit of debt equals the marginal cost.

Figuring out Optimal Capital Structure

The optimal capital structure is estimated by working out the mix of debt and equity that limits the weighted average cost of capital (WACC) of a company while boosting its market value. The lower the cost of capital, the greater the current value of the firm's future cash flows, discounted by the WACC. In this way, the chief goal of any corporate finance department ought to be to find the optimal capital structure that will result in the least WACC and the maximum value of the company (shareholder wealth).

As per financial specialists Franco Modigliani and Merton Miller, without taxes, bankruptcy costs, agency costs, and asymmetric data, in an efficient market, the value of a firm is unaffected by its capital structure.

Optimal Capital Structure and WACC

The cost of debt is more affordable than equity since it is safer. The required return expected to remunerate debt investors is not exactly the required return expected to repay equity investors, since interest payments have priority over dividends, and debt holders receive priority in the event of a liquidation. Debt is likewise less expensive than equity since companies get tax relief on interest, while dividend payments are paid out of after-tax income.

In any case, there is a limit to the amount of debt a company ought to have in light of the fact that an unnecessary 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 remunerate them, which increases the WACC — and brings down the market value of a business. The optimal structure includes utilizing sufficient equity to relieve the risk of being not able to pay back the debt — considering the variability of the business' cash flow.

Companies with reliable cash flows can tolerate a lot larger debt load and will have a lot higher percentage of debt in their optimal capital structure. On the other hand, a company with unstable cash flows will have little debt and a large amount of equity.

Deciding the Optimal Capital Structure

As it tends to be hard to pinpoint the optimal capital structure, managers as a rule endeavor to operate inside a scope of values. They likewise need to consider the signs their financing choices ship off the market.

A company with great possibilities will try to raise capital utilizing debt as opposed to equity, to stay away from dilution and conveying any negative messages to the market. Declarations made about a company taking debt are regularly viewed as positive news, which is known as debt signaling. In the event that a company raises too much capital during a given time span, the costs of debt, preferred stock, and common equity will start to rise, and as this happens, the marginal cost of capital will likewise rise.

To measure how risky a company is, potential equity investors take a gander at the debt/equity ratio. They additionally compare the amount of leverage different businesses in a similar industry are utilizing — on the assumption that these companies are operating with an optimal capital structure — to check whether the company is utilizing an unusual amount of debt inside its capital structure.

One more method for deciding optimal debt-to-equity levels is to think like a bank. What is the optimal level of debt a bank will loan? An analyst may likewise use other debt ratios to put the company into a credit profile utilizing a bond rating. The default spread joined to the bond rating can then be utilized for the spread over the risk-free rate of an AAA-rated company.

Limitations of Optimal Capital Structure

Sadly, there is no magic ratio of debt to equity to use as guidance to accomplish real-world optimal capital structure. What characterizes a solid blend of debt and equity fluctuates as per the industries in question, line of business, and a firm's stage of development, and can likewise differ over the long run due to outside changes in interest rates and regulatory environment.

Notwithstanding, on the grounds that investors are better unpleasant their money into companies with strong balance sheets, it's a good idea that the optimal balance generally ought to reflect lower levels of debt and higher levels of equity.

Speculations on Capital Structure

Modigliani-Miller (M&M) Theory

The Modigliani-Miller (M&M) theorem is a capital structure approach named after Franco Modigliani and Merton Miller. Modigliani and Miller were two economics teachers who concentrated on capital structure theory and collaborated to foster the capital structure irrelevance proposition in 1958.

This proposition states that in perfect markets the capital structure a company utilizes doesn't make any difference on the grounds that the market value of a still up in the air by its earning power and the risk of its underlying assets. As indicated by Modigliani and Miller, value is independent of the method of financing utilized and a company's investments. The M&M theorem made the two following propositions:

Proposition I

This proposition says that the capital structure is irrelevant to the value of a firm. The value of two indistinguishable firms would continue as before and value wouldn't be impacted by the decision 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.

Proposition II

This proposition says that the financial leverage helps the value of a firm and diminishes WACC. It is when tax data is free. While the Modigliani-Miller theorem is concentrated on in finance, real firms in all actuality do face taxes, credit risk, transaction costs, and inefficient markets, which makes the mix of debt and equity financing important.

Dominance hierarchy Theory

The dominance hierarchy theory centers around asymmetrical data costs. This approach accepts that companies focus on their financing strategy in view of the path of least resistance. Internal financing is the primary preferred method, trailed by debt and outer equity financing as a last resort.

Features

• An optimal capital structure is the best mix of debt and equity financing that boosts a company's market value while limiting its cost of capital.
• Limiting the weighted average cost of capital (WACC) is one method for streamlining for the least cost mix of financing.
• As per a few financial specialists, without taxes, bankruptcy costs, agency costs, and asymmetric data, in an efficient market, the value of a firm is unaffected by its capital structure.