Optimal capital structure

Optimal capital structure is a balanced set of debt and stock that helps to maximize company value (or stock price). The benefit of debt is lowest cost of capital, but accompanied with higher financial risk to shareholders. Therefore, company should find an equilibrium when benefit of debt is similar to marginal cost.

Measuring capital structure

The most popular measure that helps to optimize capital structure is WACC (weighted average cost of capital). It is a calculation of a firm's overall cost of capital in which each category of capital is proportionately weighted. All capital sources - stocks, bonds and any other long-term debt - are included in a WACC calculation.

${\text{WACC}}=\left({E \over {V}}\right)\cdot r_{E}+\left({D \over {V}}\right)\cdot r_{D}\left(1-T_{c}\right)$

where:

• $\ D$ is the value of debt,
• $\ E$ is the value of equity,
• $\ V$ is the market value of the company,
• $\ T_{C}$ is the tax rate,
• $\ r_{D}$ is the cost of debt,
• $\ r_{E}$ is the cost of equity.

Capital structure choice determinants

Variation of debt ratios theories suggest that companies select their capital structure according to their activity. Costs and profits are determined on attributes of the analyzed company and they are in connection with equity financing and debt. According to this, there are some different theories of the capital organization. Any of them can cause company's choice in its debt-equity forasmuch each theory brings up attributes that can affect this choice. The attributes are described below (S. Titman 1988, p.1-6):

• The value of asset collateral - because majority of capital structure theories contend that the kind of asset can influence choice of capital structure. One of theories suggests that companies can boost their equity's value by dispose secured debt, by dispossession of assets from their present unsecured creditors. Some of theories demonstrate that there can appear costs connected with issue of securities. Company's managers have better knowledge about those securities and their costs than external shareholders. Those costs may be avoided by selling debts that are secured by wealth with specified value. Because of that, firms that are in possession of wealth that may be used as collateral are more likely to increase their debt issue as long as they have possibility to do this.
• Non-debt tax shields - tax breaks connected with depreciation and those involved in investments are substitutes for debt financing tax benefits. Companies that can boast wide non-debt tax shields on their cash flow indicate capital structures with lower debt.
• Growth - equity-controlled companies are more likely to invest in expropriate assets from bondholders. Costs that are connected with this kind of relationship are very possible in companies that are classified as growing ones. These firms are more flexible in their future investments choices. Predicted growth can discourage investors because of its long-term debt. However, ratio which describe short-term debt may be connected with positive image of growing firms. But the most important thing to do for the company is to replace long-term financing with short-term.
• Individuality - Debt ratios are connected in the negative with unique specification of products and services. Clients, employees and suppliers that are cooperate with company that manufacture unique products are possibly at risk of high costs in case of manufacturer liquidation. Probably, suppliers and workers have got specific skills and experience, and clients do not have any substitute for product and this caused negative view of individuality.
• Industry classification - manufacturers producing products that require specialized service and spare parts are connected with high cost of liquidation. Because of this, companies producing machines and gear need to be financed with possibly the lowest debt.
• Size - Company size is attribute that leverage ratios can be connected to. Large companies have got tendency to be diversified, and because of that they have lower predisposition to bankruptcy. Issuing debt and equity securities cost is related to size of the company. Relative small companies pay more to issue equity then big firms. According to that fact, small firms are more likely to be leveraged in high level then big ones, and because of lower fixed costs may prefer to use short-term loan.
• Profitability - retained earnings are preferred way of increasing capital. Secondly, there is raising capital from debt, and finally from issuing new equity. Issuing new equity costs can be the main reason of this behavior (costs that arise in connection to asymmetric information and costs connected with transactions). Past profitability and coming from it value of earnings that have ability to retained, should be significant determinant of capital structure.

There are various of analyzes that was aiming at capital structure and was based on levarage in companies. Referring with some agency models connected with capital structure, there are many works that have noted association between company's value and leverage. Researches into reaction of stock price on security issuance and redemption announcements find that leverage-increasing ones are connected with positive reaction on stock price and leverage-decreasing with negative. Stock repurchases and debt-for-equity exchanges are examples of leverage-increasing announcements and issuing equity is example of leverage-decreasing announcement (P. Berger 1997, p.2).

Examples of Optimal capital structure

• A company that has an optimal capital structure would have a mix of debt and equity that maximizes its stock price or market value. This could include a combination of long-term debt, such as bonds, and equity, such as common and preferred stock. The debt-to-equity ratio should be carefully chosen to provide the company with the capital it needs to finance growth, while also minimizing the company's overall financial risk.
• A company that has an optimal capital structure will also be mindful of its interest rate and cost of capital. By carefully managing its debt and equity, the company can ensure that its cost of capital is as low as possible, while still providing the necessary funds for growth.
• An example of an optimal capital structure is Apple Inc., which has a debt-to-equity ratio of 0.19. This ratio is considered low, but still provides the company with the funds it needs to finance its operations and growth. Apple also has a cost of capital of 9.68%, which is considered low in comparison to other companies in its industry.

Advantages of Optimal capital structure

An optimal capital structure is a balance of debt and equity that maximizes a company's value. The following are the advantages of an optimal capital structure:

• It allows a company to access lower-cost debt capital, resulting in a lower cost of capital.
• It increases the return on equity for shareholders, since the cost of debt is lower than the cost of equity.
• It allows a company to take advantage of tax benefits associated with debt, since the interest payments are tax deductible.
• It reduces the risk associated with financial leverage, since the company is able to manage the debt load more effectively.
• It provides a more flexible capital structure, allowing the company to adjust to changing market conditions or financing needs.

Limitations of Optimal capital structure

Optimal capital structure is a balanced set of dept and stock that helps to maximize company value (or stock price). However, there are several limitations of optimal capital structure:

• It assumes that capital structure does not affect the cost of capital which is not always true. Capital structure decisions affect the cost of capital and its components, such as cost of debt and cost of equity.
• It does not take into account the costs associated with financial distress. Financial distress can be costly for the company, since it may involve liquidation costs, legal fees, and other expenses.
• It assumes that the company is able to accurately estimate the cost of capital and the cost of debt, which may not always be the case.
• It may not take into account the personal preferences of the investors, which can influence their decision to invest in the company.
• It assumes that the capital structure is static and does not take into account the dynamic nature of capital structure decisions.

Other approaches related to Optimal capital structure

• Target capital structure: This approach assumes that the optimal capital structure is determined by the external markets. Companies should focus on the debt levels and debt ratings of their peers.
• Tax shield approach: This approach suggests that a company should consider the tax benefits of debt in their capital structure decision. Higher debt levels will result in more favorable tax treatments.
• Net income approach: This approach suggests that a company should choose a capital structure based on the after-tax income generated by the firm. The idea is to maximize the return on equity by minimizing the cost of capital.
• Cash flow approach: This approach suggests that a company should consider the cash flow generated by its capital structure. Companies should use their cash flow to pay off debt and reinvest in the business.

In summary, optimal capital structure is an important decision for companies as it affects the cost of capital, risk, and return on investment. Companies should consider various approaches, such as target capital structure, tax shield approach, net income approach, and cash flow approach, when deciding on their optimal capital structure.

Optimal capital structure — recommended articles

Capital rationing — Degree of financial leverage — Return on net assets — Capital gearing — Plowback Ratio — Capital Base — Appropriation of retained earnings — Borrowing Base — Growth shares

References

• Ang, J. R. D., Tan, M. C., & Telmo, J. A. R. (2015, January). Exploring the existance of optimal capital structure and its effects on tax arbitrage and shareholder wealth creation in the Philippine real estate industry. In Global Conference on Business & Finance Proceedings (Vol. 10, No. 1, p. 368). Institute for Business & Finance Research.
• Baker M., Wurgler J., (2002, February). Market timing and capital structure. "The journal of finance" (Vol. 57, No. 1, p. 1).
• Berger, P. G., Ofek, E., Yermack, D. L. (1997). Managerial entrenchment and capital structure decisions. "The journal of finance" (Vol. 52, No. 4, p. 1411-1438).
• Bradley M., Jarrell G. A., Kim H. (1964, July). On the existance of an optimal capital structure: theory and evidence "The journal of finance" (vol. 39, No. 3, p.857-878).
• Titman, S., Wessels R. (1988, March). The determinants of capital structure choice. "The journal of finance" (vol. 43, No. 1, p. 1).

Author: Maciej Soczówka