Optimal Capital Structure

An optimal capital structure is the objectively best mix of debt, preferred stock, and common stock that maximizes a company’s market value while minimizing its cost of capital.

In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost.

According to economists Modigliani and Miller, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information; and in an efficient market, the value of a firm is unaffected by its capital structure.

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

The Modigilani-Miller (M&M) theorem is a capital structure approach named after Franco Modigliani and Merton Miller in the 1950s. Modigliani and Miller were two economics professors who studied capital structure theory and collaborated to develop the capital-structure irrelevance proposition. 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. The M&M theorem made two propositions:

• Proposition I: 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 finance 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 boosts the value of a firm and reduces WACC. It is when tax information is available.

Pecking Order Theory

The pecking order theory focuses on asymmetrical information costs. This approach assumes that companies prioritize their financing strategy based on the path of least resistance. Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.

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 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. The optimal structure involves using enough equity to mitigate the risk of being unable to pay back the debt — taking into account the variability of the business’ cash flow.

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 flow will have little debt and a large amount of equity.

As it can be difficult to pinpoint the optimal 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.

To gauge how risky a company is, potential equity investors look at the debt/equity ratio. 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 an 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.