INANCIAL MANAGEMENT

Optimal Capital Structure

Presented by:
Ramesh Pant
BBM-18
Fourth Semester

The Optimal Capital

Structure

Maximizes shareholder wealth

Maximizes firm value
Maximizes stock price
Minimizes WACC
Does NOT maximize EPS
Optimal Capital Structure - that mix of debt
and equity which maximizes the value of
the firm or minimizes the cost of capital

Estimating the Optimal Capital

Structure: 5 Steps
1. Estimate the interest rate the firm
2.
3.
4.
5.

will pay (cost of debt)

Estimate the cost of equity
Estimate the WACC
Estimate the free cash flows and
their present value (value of the
firm)
Deduct the value of debt to find
Shareholder Wealth Maximize

Optimal Capital
Structure
An optimal capital structure is the optimal
ratio of debt and equity that is used to
finance a company's assets.
Conventionally, the ratio is said to be optimal
when itminimizes the company's Cost of
Capital, which is defined as a sum of the
costs of debt and equity for the company
weighted to their respective debt/equity
proportions used by the company.

 Thecost of debtdepends on factors

like market interest rates, default risk of
the company, existing debt levels, as
well as the marginal tax rate applicable.
Thecost of equitydepends on factors
like market interest rates, average
returns of the market/industry, and
volatility of the company's stock.

 There is alsosubstantial interplay between the

two costs. For instance, higher debt levels will
increase cost of equity as equity investors will view a
debt laden firm as riskier. At the same time, this
might be offset from a greater tax advantage enjoyed
due to higher debt levels (interest payments are taxdeductible while dividends are not).
Thus, optimal capital structure is theright amount
of debt and equity that, taking into account all the
factors above, minimizes the company's cost of
capital.

 Note that this concept of an optimal capital

structure islargely theoretical.
In the real world, there are other factors affecting
capital financing that are not captured in such
theoretical models.
For instance, a company with volatile revenues
might want to keep low debt levels since interest
payments are fixed, regardless of the company's
performance, while dividends are flexible.
For another, low debt levels mean high credit
ratings, which have a managerial ego factor
associated with them. Whether this is in the best
interests of shareholders is another matter.

 In conclusion, optimal capital

structure serves as a good long-term
indicator of where a firm might be
headed with its debt/equity mix, but
in the short run, you'll often find
companies different from the optimal
for genuine, reasonable reasons.