University of Central Punjab

Course Title

Financial Management

Program: BS(Accounting & Finance) Section: E

Semester: 3rd
Submitted to: Prof. Abid Noor
Submitted by: Muhammad Ahmed (L1f18bsaf7010)
Syed Muhammad Jafer (L1f18bsaf7030)
 Optimal Capital Structure
Definition: 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.

The Basics of Optimal 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 Modigliani-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 1:
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 2:
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.

Special Considerations:
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 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 a little debt and a large amount of equity.

Changes in Capital Structure Send Signals to the Market

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 prospectus 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 on 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 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.

Limitation to Optimal Capital Structure:

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.

Net income approach:

Net Income Approach was presented by Durand. The theory suggests increasing value of
the firm by decreasing the overall cost of capital which is measured in terms of Weighted
Average Cost of Capital. This can be done by having a higher proportion of debt, which is
a cheaper source of finance compared to equity finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and
debts where the weights are the amount of capital raised from each source.
According to Net Income Approach, change in the financial leverage of a firm will lead to
a corresponding change in the Weighted Average Cost of Capital (WACC) and also the
value of the company. The Net Income Approach suggests that with the increase in
leverage (proportion of debt), the WACC decreases and the value of firm increases. On
the other hand, if there is a decrease in the leverage, the WACC increases and thereby
WACC = Required Rate of Return x Amount of Equity + Cost of debt x Amount of
Debt
Total Amount of Capital (Debt + Equity)
the value of the firm decreases.
Assumptions:
Net Income Approach makes certain assumptions which are as follows.
o There is no flotation cost, no transaction cost and corporate dividend tax.
o There are only two sources of finance; debt and equity. There are no sources of
finance like Preference Share Capital and Retained Earning.
o All companies have uniform dividend payout ratio; it is 1.
o Capital market is perfect, it means information about all companies are available
to all investors and there are no chances of over pricing or underpricing of security.
Further it means that all investors are rational. So, all investors want to maximize
their return with minimization of risk.
o All sources of finance are for infinity. There are no redeemable sources of finance.
o The increase in debt will not affect the confidence levels of the investors.

Example:

Earnings before Interest Tax (EBIT) = 200,000

Bonds (Debt part) = 400,000
Cost of Bonds issued (Debt) = 30%
Cost of Equity = 25%

Calculating the value of a company.

 EBIT = 200,000
Less: Interest cost (30% of 400,000) = 120,000
Earnings (since tax is assumed to be absent) = 80,000
Shareholders’ Earnings = 80,000
Market value of Equity (80,000/25%) = 3200,000
Market value of Debt = 400,000
Total Market value = 3600,000
Overall cost of capital = EBIT/(Total value of firm)
= 200,000/3600,000
= 5.55%

Now, assume that the proportion of debt increases from 400,000 to 600,000 and
everything else will be same.
(EBIT) = 600,000
Less: Interest cost (30% of 600,000) = 180,000
Earnings (since tax is assumed to be absent) = 420,000
Shareholders’ Earnings = 420,000
Market value of Equity (420,000/25%) = 1680000
Market value of Debt = 600,000
Total Market value = 2280000
Overall cost of capital = EBIT/(Total value of firm)
 = 600,000/2280000
= 26.31%

As observed, in case of Net Income Approach, with increase in debt proportion, the total
market value of the company increases and cost of capital decreases. Reason for this is
that assumption of NI approach that irrespective of debt financing in capital structure,
cost of equity will remain same. Cost of debt is always lower than cost of equity, so with
increase in debt finance WACC reduces and value of firm increase.