This is “Choosing the Optimal Capital Structure”, section 15.4 from the book Finance for Managers (v. 0.1). For details on it (including licensing), click here.
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15.4 Choosing the Optimal Capital Structure
PLEASE NOTE: This book is currently in draft form; material is not final.
Learning Objectives
- Describe the process of determining the optimal capital structure.
- Given costs of capital for various capital structures, determine the optimal capital structure for a firm.
Primarily, the choice of capital structure affects the cost of capital for each of the components of WACC. On the whole, companies tend to avoid the extreme amounts of debt that can have drastic influence on operating cash flows; only in extremely distressed companies do we need to consider significant changes to free cash flows. Therefore, the decision on optimizing capital structure is relatively independent from capital budgeting decisions.
Specifically, it is a goal of financial managers to choose a capital structure that minimizes WACC, which will, in turn, maximize the value of the firm. Since our WACC is the basis for discounting used in finding the NPV of projects (or the hurdle rate with which IRR is compared), a lower WACC will increase the value of our conventional positive NPV projects, and cause some conventional projects that were originally rejected to cross the threshold into value-adding propositions.
Consider the following projections by financial managers at firm XYZ:
Table 15.1 Cost of Capital Projections
| % debt | cost of debt | after-tax cost of debt | % equity | cost of equity | WACC |
|---|---|---|---|---|---|
| 0% | 5.0% | 3.0% | 100% | 7.0% | 7.00% |
| 10% | 5.0% | 3.0% | 90% | 7.3% | 6.84% |
| 20% | 5.2% | 3.1% | 80% | 7.6% | 6.70% |
| 30% | 5.5% | 3.3% | 70% | 8.0% | 6.61% |
| 40% | 5.8% | 3.5% | 60% | 8.6% | 6.55% |
| 50% | 6.2% | 3.7% | 50% | 9.4% | 6.56% |
| 60% | 6.8% | 4.1% | 40% | 10.6% | 6.69% |
| 70% | 7.5% | 4.5% | 30% | 12.6% | 6.93% |
| 80% | 8.5% | 5.1% | 20% | 16.6% | 7.40% |
| 90% | 10.0% | 6.0% | 10% | 28.6% | 8.26% |
| 100% | 16.0% | 9.6% | 0% | 45.0% | 9.60% |
Assuming firm XYZ’s tax rate to be 40% and given the projected costs of capital at each level of debt and equity, we can see that WACC is minimized at a 40%/60% debt/equity mix. Below this mix, we aren’t utilizing enough of the cheaper debt. Above this level, the increased costs of both debt and equity cause WACC to increase as we add more debt to the mix.
In practice, we are rarely able to precisely know what the cost of capital will be for our company at specific levels of debt. We can create estimates based upon observed costs at other companies, but short of trying a new capital structure, it is impossible to know for certain what the precise WACC will be.
Key Takeaway
- The optimal capital structure is the one that maximizes firm value by minimizing WACC.
Exercise
-
What is the optimal level of debt given the following projected WACC values:
0% debt = 7.8% WACC
10% debt = 7.5% WACC
20% debt = 7.4% WACC
30% debt = 7.3% WACC
40% debt = 7.4% WACC
50% debt = 7.6% WACC
60% debt = 8% WACC
70% debt = 8.6% WACC
80% debt = 10% WACC