Secondary market liquidity and the optimal capital structure david m. Jan 20, 2011 we study optimal capital structure by first estimating firmspecific cost and benefit functions for debt. Some legal and policy issues by professor stewart c. Hence, it does not matter how we introduce the financing frictions.
Optimal capital structure free download as powerpoint presentation. This paper presents a continuous time model of a firm that can dynamically adjust both its capital structure and its investment choices. Capital structure categorizes the way a company has its assets financed. Unfortunately, there has been little consensus among researchers on what the optimal capital structure is. 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. Optimal corporate investments and capital structure. The first question to address is what is meant by capital structure. In this paper, we analyze the effect of acquisitions from accounting and market perspectives. Investors face a progressive tax rate on returns from bonds, tpb, while the firm faces a constant statutory marginal tax rate, tc.
Optimum capital structure and cost of capital n if the cash flows to the firm are held constant. We study optimal capital structure by first estimating firmspecific cost and benefit functions for debt. Questions on capital structure optimal capital structure. The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. Pdf optimal capital structure and growth options in mergers and. This pdf is a selection from an outofprint volume from. Mergers, capital structure and risk semantic scholar. Mergers in kenya banking industry have grown dramatically since 1994. The cost functions are upward sloping, reflecting the rising costs that occur as a firm increases its use of debt. What defines a healthy blend of debt and equity varies according to the. However, this particular cost was not stressed by jensen and meckling. An optimal capital structure is the best debttoequity ratio for a firm that maximizes its value. Optimal capital structure and industry dynamics 2625 flows at a constant riskfree rate r 0. Optimal capital structure financial definition of optimal.
Sheridan, a dynamic model of optimal capital structure november 25, 2005. The target ratio may change over time as the firms performance and environments change. Chapter 4 optimal capital structure deci sion in a multicriteria. Their theory of optimal capital structure is based on different phenomena. Chapter 3 develops a model where capital structure decisions are centered around the firms liquidity needs, while still accounting for tax benefits, the cost of financial distress and collateral. Explain the influence of a companys cost of capital on its capital structure and therefore its value. Structure the deal as a stock purchase agreement rather than a merger so that all stockholders sign the agreement hold a portion of the purchase price in escrow, which may be decreased as stockholders sign support agreements put temporal and monetary limits on the indemnification obligations to increase the likelihood of enforceability. The modern theory of the capital structure originated from the path breaking contribution of modigliani. Is there an optimal capital structure for your firm. Throughout the model is compared with that set forth by modigliani and miller. Being able to make specific, firmbyfirm debt policy recommendations is an important addition to the current state of affairs.
It is the mix of debt, preferred stock and common equity that maximizes profits. What is the best capital structure depends on several factors. View topic 5 dq 1 from dq 1 at grand canyon university. Capital structure considerations boundless finance. Capital structure management capital structure strategy. Estimate the cost of capital at different levels of debt 4. Optimal capital structure typically refers to the best mix of debt and equity to fund a business.
Capital would flow directly to its most efficient use. If a firm finances its activities with debt, the creditors expect the amount of the interest and principal fixed, legal commitments to be paid back as promised. With a high initial value of f, the economy starts with a high degree of selffinance, which diminishes over time. The optimal capital structure of a business is that blend of debt and equity financing being used that minimizes its weightedaverage cost of capital while at the same time maximizing its market value.
However, the more debt a company takes on, the more cash it has to generate sales. Chapter iii concepts and theories of capital structure and profitability. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the wacc. Napoli pizza wants to determine its optimal capital structure. This pdf is a selection from an outofprint volume from the national bureau of economic research volume title. Trade off theory assumes that firms have one optimal debt ratio and firm trade off 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.
It is the employment of an asset source of finance for which. Debt, equity or preferred stock b the cost of each component n in summary, the cost of capital is the cost of each component weighted by its relative market value. The ability of an organization to perform well in the market depends on the efficiency of its capital structure. Jul 23, 20 refer to overseeing the capital structure as capital structure management. Nov 19, 2002 tsyplakov, sergey and titman, sheridan, a dynamic model of optimal capital structure november 25, 2005. It is the mix of debt, preferred stock and common equity that minimizes risk. Therefore, it is the duty of all finance managers to find the optimal capital structure that will result in the lowest wacc. Refer to overseeing the capital structure as capital structure management. Calculate the effect on firm value and stock price. Pdf optimal capital structure and growth options in mergers. Meaning and definition of optimal capital structure. How this would fit in with the companys capital expenditures, growth plans. The more debt a company has, the more it has to pay creditors for the use of those funds.
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. Optimum capital structure f9 financial management acca. Capital structure means the proportion of debt and equity in the total capital of a firm. The case will also introduce students to the concept of levered betas. The lower the cost of capital, the greater the present value of the firms future cash flows, discounted by the wacc. Pdf despite a vast literature on the capital structure of the firm there still is a big gap between. Firms that incur external financing costs face a complex. The major limitation of this study is rooted in the selection of five companies. How would a financial manager determine optimal capital structure. While making any recommendations regarding the selection of optimal capital structure, there is a need to acknowledge that no readymade solution is available that could be used to develop optimal capital structure, however, effective. Capital structure definition is the makeup of the capitalization of a business in terms of the amounts and kinds of equity and debt securities. Pdf optimal capital structure and growth options in.
Making capital structure support strategy the issue is more nuanced than some pundits suggest. The optimal capital structure indicates the best debttoequity ratio for a firm that maximizes its value. Pdf we develop and empirically test a dynamic tradeoff model for the analysis of the optimal capital structure in mergers and acquisitions. They invested many hours in solving this merger and. By focusing exclusively on mergers that occurred, we were able to. Some of the reasons put forward for mergers are to meet the increased levels of share capital, market share, firm size, information asymmetry, tax regimes, and to benefit from best. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. Capital structure how a company finances its operations. The objective of a firm is to maximize the value of its business. The impact of adjustment in capital structure in mergers. In the third section the capital structure properties of the model are derived. Capital structure the makeup of the liabilities and stockholders equity side of the balance sheet, especially the ratio of debt to equity and the mixture of short and long maturities.
Apr 24, 2020 capital structure definition is the makeup of the capitalization of a business in terms of the amounts and kinds of equity and debt securities. This is the ebit reported in the current income statement reported interest expenses number of years embedded in yr 6 estimate. This structure seeks to lower the cost of capital so that a firm is less dependent on creditors and more able to finance its core operations through equity. This is the maximum amount of credit that can be extended by lenders. Pdf effect of mergers on capital structure of a firm. Starting with the seminal work by modigliani and miller, much attention has been paid to the optimality of capital structure from the shareholders point of view. Making capital structure support strategy mckinsey. In addition, using an optimal capital structure when valuing a controlling interest avoids one of the biggest drawbacks created when using an actual capital structure in the appraisal of a business. We show that capital structure decisions can be framed as multiple criteria decision. More recent papers within this group have demonstrated optimal capital structure without relying on exogenous leveragerelated costs by suggesting that the presence. Not only is it shown that an optimal capital structure can exist, but conditions which guarantee the existence of a unique internal optimal level of debt are set forth.
Debt financing is less expensive than equity financing, since the interest expense associated with debt is tax deductible, while dividend payouts are not tax deductible. Alternative methods to determine optimal capital structure. Using an optimal capital structure in business valuation. By implementing an optimal capital structure, a hypothetical owner tries to maximize returns without incurring undue risk. The benefit functions are downward sloping reflecting that the incremental value of debt declines as more debt is used. More recent papers within this group have demonstrated optimal capital structure without relying on exogenous leveragerelated costs by. When firms adjust their capital structure, they tend to move toward an optimal debt ratio consistent with the historical financial behaviors of firms. 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. The capital structure decision aswath damodaran stern school of business. A companys optimal mix of capital is the combination of sources of capital that yields the lowest weighted average cost of capital.
Under stable market conditions, a company can compute its optimal mix of capital. Capital structure is defined as the mix of debt and equity securities used to. Optimal capital structure default spreads and ratios operating leases marginal tax rate by country inputs faqs read me 1st from the current financial statements, enter the following reported operating income ebit. Thus, the evidence provided in this study may be viewed as a complementary to the above timeseries evidence. In capital structure models, the valuation of corporate securities and. Is it possible to increase shareholder wealth by changing the capital structure. Whether or not an optimal capital structure exists is one of the most important and complex issues in cooperate finance. For a company, optimal capital structure depends on. Rappoport, and alexandros vardoulakis 2015031 please cite this paper as. The optimal capital structure for a company is one that offers a. Debt financing is less expensive than equity financing, since the interest expense ass. In our paper, optimal capital structure, which was recently made publicly available on ssrn, we develop a method that can be used to determine optimal capital structure for any given firm. The assumption of risk neutrality does not lose any generality. The adjustment of capital structure in mergers and.
Failure to pay may result in legal actions by the creditors. Secondary market liquidity and the optimal capital structure, finance and economics discussion series. A dynamic model of optimal capital structure by sergey. The optimal capital structure is the mix of debt and equity that maximizes a firms return on capital, thereby maximizing its value. The concept of optimal capital structure has drawn a great deal of attention in accounting and finance literature. Topic 5 dq 1 how would a financial manager determine. Despite a vast literature on the capital structure of the firm there still is a big gap between theory and practice. Optimal capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value of the firm.
It is the mix of debt, preferred stock and common equity that minimizes the weighted cost of the firms employed capital. Hence, theories of capital structure often assume some cost of bankruptcy that increases in debt, and derive optimal capital structure as the balance between the tax benefit and the bankruptcy cost. The suboptimal investment policy is an agency cost induced by risky debt. The challenge is in finding the right equilibrium between debt and equity for an optimal capital structure, which can then be leveraged to grow the business. The capital asset pricing model capm, the weighted average cost of capital model wacc, and levered beta estimates are used to estimate per share stock values at a variety of debt. In capital structure models, the valuation of corporate securities and financial decisions are jointly determined. A read is counted each time someone views a publication summary such as the title, abstract, and list of authors, clicks on a figure, or views or downloads the fulltext. Pdf despite a vast literature on the capital structure of the firm there still is a big gap between theory and practice. 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 share superficially through share buybacks. Optimizing a company s capital structure is critical to its ability to achieve nearand longterm growth objectives. The capital structure referred to enterprise includes mixture of debt and equity financing. Secondary market liquidity and the optimal capital structure.
The three most basic ways to finance are through debt, equity or the issue of stock, and, for a small business. An empirical model of optimal capital structure scholarlycommons. 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. If agents are risk averse, the analysis may be conducted under the riskneutral measure see harrison and kreps 1979. The optimal capital structure should ensure companies retain sufficient capital levels during both good times and bad.
However, it is important to synthesise the literature on capital structure and where possible, to relate the literature to known empirical evidence. Ensuring an optimal capital structure and securing the financing sources with the least cost of capital is as important, if not more, for corporate entities as it is for individuals. Capital structure definition of capital structure by. The capital structure models incorporate contingent claim valuation theory to quantitatively analyze prevailing determinants of capital structure in corporate finance literature. Optimal capital structure capital structure is the proportion of debt and preference and equity shares on a firms balance sheet. Optimal capital structure is the mix of debt and equity financing that. Another way to generate balanced conclusions is to account for personal taxes. Given that firms are allowed to choose their optimal capital structure, they will choose a larger share of finance from financial intermediaries, the more productive is the financial intermediary.