The theory and practice of corporate capital structure january 2006 2 liability strategies group executive summary this paper discusses the theory and practice of corporate capital structure, drawing on results from a recent survey. An optimal capital structure is the best debttoequity ratio for a firm that maximizes its value. This paper develops a precise method of estimating the cost of debt to a firm that is based on standard financial theories and empirical evidence on default risk and financial distress costs. Since capital structure is the amount of debt or equity or both employed by a firm to fund its operations and finance its assets, capital structure is typically expressed as a debttoequity ratio.
Therefore, the search for the optimal capital structure becomes the search for the lowest wacc, because when the wacc is minimised, the value of the companyshareholder wealth is maximised. Capital structure affects a companys overall value through its impact on operating cash flows and the cost of capital. Dhankar, cost of capital, optimal capital structure, and value of firm. This enables the company to minimize the cost of capital. The theory provides insight into a firms capital structure decision in a capital market free of taxes, transaction costs. Making capital structure support strategy mckinsey. Optimal capital structure cost of capital capital structure. Jun 25, 2019 the debt capital in a companys capital structure refers to borrowed money that is at work in the business. Meaning and definition of optimal capital structure.
The optimal capital structure indicates the best debttoequity ratio for a firm that maximizes its value. Debt is cheaper than equity, so a moderate increase in debt will help to reduce the cost of capital. Capital structure theories help us to understand the relationship between the capital structure, cost of capital and value of a firm. Determinants of capital structure mba knowledge base. Despite a vast literature on the capital structure of the firm there still is a big gap between theory and practice. The special thing about this approach is that it believes an optimal capital structure. Capital structure describes the amount of debt a company uses as opposed to equity, and it is often measured with the ratio of debt to equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Making capital structure support strategy the issue is more nuanced than some pundits suggest. Constraints in designing optimal capital structure. The need for separate valuation partly arises from new international accoun.
An optimal capital structure is one that minimizes the firms cost of capital and thus maximizes firm value. In theory, it may be possible to reduce capital structure to a financial calculation to get the most tax benefits by favoring debt, for example, or to boost earnings per. Under stable market conditions, a company can compute its optimal mix of capital. However, determining an optimal capital structure, which in turn, is. The lower the cost of capital, the greater the present value of the firms future cash flows, discounted by the wacc. Capital structure, cost of capital, and voluntary disclosures jeremy bertomeu, anne beyer, and ronald dye stanford university, northwestern university october 2009 abstract this paper develops a model of external nancing that jointly determines a rms capital structure, its voluntary disclosure policy, and its cost of capital. An empirical study of indian companies raj s dhankar and a jit s boora introduction academicians and practitioners alike have found it difficult to resolve the issue of optimal capital structure in the perfect capital markets of the west as well as in the. 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.
Cost of capital, optimal capital structure, and value of. Jensen and meckling argue that an optimal capital structure can be obtained by trading off the agency cost of debt against the benefit of debt as previously described. As per this notion, the firm should rely more on the equity share capital instead of the debt capital, because the higher the use of debt in the capital structure, the higher is the commitment as to interest. This paper presents a multiperiod model of firm valuation which captures the costs of bankruptcy and implies the existence of a unique optimal capital structure. The theory of capital structure harris 1991 the journal. However, since the wacc will remain unchanged, the cost of the extra finance will be equal to the wacc. Theoretical considerations a firm could use three methods to determine its capital structure. The relative levels of equity and debt affect risk and cash flow and, therefore, the amount an investor would be willing to pay for the company or for an.
To calculate the optimal capital structure of a firm, analysts calculate the weighted average cost of capital wacc to determine the level of risk that makes the expected return on capital greater than the cost of capital. Capital structure chapter 15 and chapter 16 contents i. The cost functions are upward sloping, reflecting the rising costs that occur as a firm increases its use of debt. The optimal debt ratio is the one that maximizes the overall value of the. If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be.
Since the interest expense on debt is tax deductible in most countries, a company can reduce its aftertax cost of capital by increasing debt relative to equity, thereby directly increasing its intrinsic value. The capital structure decision aswath damodaran stern school of business. Adding the tax shield provided by debt to the modigliani and miller framework suggests that the optimal capital structure is all debt. Oct 02, 2019 the traditional theory of capital structure states that when the weighted average cost of capital wacc is minimized, and the market value of assets is maximized, an optimal structure of capital. An optimal capital structure is such that the overall cost of capital is minimum whereas the earnings per share are maximum. Chapter iii concepts and theories of capital structure and profitability. A practical contemporary approach 1 introduction astute financial managers agree that investment in assets and managing operations create the greatest opportunities for profitseeking companies to maximize shareholders wealth. The swiss army knife of finance aswath damodaran april 2016 abstract there is no number in finance that is used in more places or in more contexts than the cost of capital. A major function of a financial manager is to determine the optimal capital structure for a company i.
It proposes that there is an optimal capital structure where the wacc is at minimum and the value of the firm is at maximum. At this capital structure the market price per share is maximum and cost of. Calculate the effect on firm value and stock price. This is the only way that the financing costs and the weighted average cost of capital wacc are minimised thereby increasing firm value and. Apr 26, 2019 we have examined whether there exists an optimal capital structure in indian companies, both at the micro and the macrolevel and whether financing decisions affect the value of a firm. Capital structure, cost of capital, and voluntary disclosures. Therefore, the capital structure which increases firm value or minimizes total cost of capital is claimed to be the optimum capital structure. However, it is important to synthesise the literature on capital structure and where possible, to relate the literature to known empirical evidence. Cost of capital each source of financing has a different cost the wacc is the weighted average cost of capital capital. The cost of capital is the companys cost of using funds provided by creditors and shareholders. It refers to the way how companies finance their assets, how much it costs them and what they risk with it. The capital structure of a firm is designed in such a manner that the cost of capital is kept at. There are disadvantages such as low proportion of internal financing, single external financing channels and excessive shortterm liabilities. An optimum capital structure has such a proportion of debt and equity which will maximise the wealth of the firm.
The more debt a company has, the more it has to pay creditors for the use of those funds. From table 3, it can be observed that t value for cost of debt is. How capital structure affects business valuation santora. Analysis on the factors affecting the capital structure of. Pdf a precisely practical measure of the total cost of. The optimal structure of the capital is the structure that ensure an optimum balance between risk and income and, so, maximise the enterprise. The article discusses the direction of modification of methods for calculating the optimal capital structure based on compromise theories and, in particular, the method of adjusted cost, which.
The cost depends on the health of the companys balance sheeta triple aaa rated firm can borrow at extremely low rates vs. At present, the capital structure of small and mediumsized enterprises in china is unreasonable. Optimum capital structure and cost of capital n if the cash flows to the firm are held constant. The benefit functions are downward sloping reflecting that the incremental value of debt declines as more debt is used. The financial structure influence on the cost of capital and. Of course, cost of capital is to a certain extent debatable aspect of financial management. As more debt is added to the capital structure of a firm, the cost of debt capital a. How do taxes affect capital structure andrew mackinlay january 2012 abstract i. The company cost of capital expected return on assets. Jan 20, 2011 we study optimal capital structure by first estimating firmspecific cost and benefit functions for debt.
Explaining analysis of the relationship between capital. Aswath damodaran april 2016 abstract new york university. Putting it simple, the optimal capital structure for a company is the one which proffers a balance between the idyllic debttoequity ranges thus minimizing the firms cost of capital. Capital structure planning refers to the designing of an appropriate capital structure in the context of the facts and circumstances of each firm. Study 19 terms capital structure i flashcards quizlet. It is one of the bases of the theories of financial management. One of the capital structure theories known as the net operating income noi approach maintains that a firms cost of capital is independent of leverage and its value is not affected by capital structure. The combination of debt and equity used to finance a companys projects is referred to as capital structure.
Optimum capital structure and cost of capital n if the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized. Therefore, it is the duty of all finance managers to find the optimal capital structure that will result in the lowest wacc. We know that changing the capital structure does not change the company cost of capital. A study on determinants of capital structure in india.
Cost of capital, optimal capital structure, and value of firm. Analogously, optimal capital structure occurs where the marginal benefit of debt equals the marginal cost of debt, which we can approximate in our approach. We study optimal capital structure by first estimating firmspecific cost and benefit functions for debt. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of the firm is maximum. The optimum capital structure may be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm. This structure seeks to lower the cost of capital so that a firm is less dependent on. Let us make an indepth study of the meaning and features of the optimum capital structure of a firm. The debt capital in a companys capital structure refers to borrowed money that is at work in the business. Therefore the optimal capital structure strikes a balance between risk and return. The capital structure of a firm is some mix of debt, internally generated equity, and new equity. At this capital structure the market price per share is maximum and cost of capital is minimum. Aswath damodaran 2 pathways to the optimal the cost of capital approach. The company cost of capital is a weighted average of the expected returns on the debt and equity.
The next l ecture addresses these other factors and extends the theory. The company cost of capital is a weighted average of the expected returns on the debt and. Hence there exists a relation between capital structure and cost of capital. Pdf capital structure and the cost of capital researchgate. Starting with the seminal work by modigliani and miller, much attention has. Estimate the cost of capital at different levels of debt 4. Jul 23, 20 refer to overseeing the capital structure as capital structure management. Refer to overseeing the capital structure as capital structure management. Optimum capital structure f9 financial management acca. A companys cost of capital is the cost of its longterm sources of funds.
They suggest that managers of a firm should be able to identify when the optimal capital structure is attained and try to maintain it at that level. Top 4 theories of capital structure with calculations. An empirical study of indian companies, vikalpa, vol. Unfortunately, there has been little consensus among researchers on what the optimal capital structure is. The optimal capital structure for a company is one that offers a. The optimal debt ratio is the one that minimizes the cost of capital for a.
The optimal structure would be to have virtually no equity at all, i. To calculate the optimal capital structure of a firm, analysts calculate the weighted average cost of capital wacc to determine the level of risk that makes the expected return on capital greater. This content was copied from view the original, and get the alreadycompleted solution here. The capital structure of small and mediumsized enterprises is closely related to enterprise financing. Objective number 1e was to study and analyse the determinants of capital structure of indian companies by investigating the impact of cost of debt on short term debt. Third, many of the variables that are believed to affect optimal capital structure are difficult or impossible to measure. Chapter 6 is about the cost of capital for the separate valuation of intangible assets. May 29, 2019 a companys capital structure refers to how it finances its operations and growth with different sources of funds, such as bond issues, longterm notes payable, common stock, preferred stock, or. In the modigliani and miller propositions with and without taxes, increasing a companys relative use of debt in the capital structure increases the risk for equity providers and, hence, the cost of equity. Pathways to the optimal the cost of capital approach.
The target capital structure is therefore that combination of longterm sources of finance that leads to the lowest wacc and, consequently, to the highest value for. If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. Pdf a precisely practical measure of the total cost of debt. In corporate finance, it is the hurdle rate on investments, an optimizing tool for capital structure. Optimal capital structure free download as powerpoint presentation. Hence, if we can change the capital structure to lower the wacc, we can then increase the market value of the company and thus increase shareholder wealth. Optimal capital structure often also referred as or optimal financing mix is one of the basic things required for a sound business. Elliott athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. Capital structure and its 4 important theories ni, noi. With increase in borrowings, wacc gradually reduces, and the value of.
The cost of capital of the firm will not change with leverage. Pdf capital structure is still a puzzle among finance scholars. Explaining analysis of the relationship between capital structure. Capital structure management capital structure strategy.
And the cost of each source reflects the risk of the assets the company invests in. Implications for the debt policy of the regulated firm are also considered. Optimal capital structure is a financial measurement that firms use to determine the best mix of debt and equity financing to use for operations and expansions. Capital structure, a reading prepared by pamela peterson drake 1. This is the maximum amount of credit that can be extended by lenders. In general, the optimal capital structure is a mix of debt and equity that seeks to lower the cost of capital and maximize the value of the firm. Optimal capital structure is the mix of debt and equity financing that maximizes a companys stock price by minimizing its cost of capital. The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the lowest weighted average cost of capital waccwaccwacc is a firms weighted average cost of capital and represents its blended cost of capital including equity and debt. How capital structure affects business valuation a companys capital structure essentially, its blend of equity and debt financing is a significant factor in valuing the business. The traditional theory of capital structure states that when the weighted average cost of capital wacc is minimized, and the market value of assets is maximized, an optimal structure of capital. It says that the cost of capital is a function of the capital structure. A companys optimal mix of capital is the combination of sources of capital that yields the lowest weighted average cost of capital. The article discusses the direction of modification of methods for calculating the optimal capital structure based on compromise theories and, in particular, the. The traditional theory states that there is an optimal financial structure that maximizes the enterprise value of a company by the use of debt and the leverage it offers.
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