Compiled by Jeemit Shah

The optimal capital structure of a firm is the best mix of debt and equity financing 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 optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company 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 cost of debt is less expensive than equity because it is less risky. The required return needed to compensate debt investors is less than the 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’s 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 flows will have little debt and a large amount of equity.

A company with good prospects 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.

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.

## Theories on Capital Structure

### Modigliani-Miller (M&M) Theory

**The M&M Theorem in Perfectly Efficient Markets**

This is the first version of the M&M Theorem with the assumption of perfectly efficient markets. The assumption implies that companies operating in the world of perfectly efficient markets do not pay any taxes, the trading of securities is executed without any transaction costs, bankruptcy is possible, but there are no bankruptcy costs, and information is perfectly symmetrical.

Proposition 1 (V_{L} = V_{U})

Where:

VU = Value of the unlevered firm (financing only through equity)

VL = Value of the levered firm (financing through a mix of debt and equity)

The first proposition essentially claims that the company’s capital structure does not impact its value. Since the value of a company is calculated as the present value of future cash flows, the capital structure cannot affect it. Also, in perfectly efficient markets, companies do not pay any taxes. Therefore, the company with a 100% leveraged capital structure does not obtain any benefits from tax-deductible interest payments.

Proposition 2

Where:

r_{E} = Cost of levered equity

r_{A} = Cost of unlevered equity

r_{D} = Cost of debt

D/E = Debt-to-equity ratio

The second proposition of the M&M Theorem states that the company’s cost of equity is directly proportional to the company’s leverage level. An increase in leverage level induces a higher default probability to a company. Therefore, investors tend to demand a higher cost of equity (return) to be compensated for the additional risk.

**M&M Theorem in the Real World**

Conversely, the second version of the M&M Theorem was developed to better suit real-world conditions. The assumptions of the newer version imply that companies pay taxes; there are transaction, bankruptcy, and agency costs; and information is not symmetrical.

Proposition 1 (V_{L }= V_{U }+ (t_{C} X D)

Where:

T_{C} = Tax rate

D = Debt

The first proposition states that tax shields that result from the tax-deductible interest payments make the value of a levered company higher than the value of an unlevered company. The main rationale behind the theorem is that tax-deductible interest payment positively affect a company’s cash flows. Since a company’s value is determined as the present value of the future cash flows, the value of a levered company increases.

Proposition 2

The second proposition for the real-world condition states that the cost of equity has a directly proportional relationship with the leverage level.

Nonetheless, the presence of tax shields affects the relationship by making the cost of equity less sensitive to the leverage level. Although the extra debt still increases the chance of a company’s default, investors are less prone to negatively reacting to the company taking additional leverage, as it creates the tax shields that boost its value.

### Trade-Off Theory

The term trade-off theory is commonly used to describe a group of associated theories. In all these theories, a decision maker examines the different costs and advantages of alternative leverage plans. The tradeoff theory assumes that you can get benefits to leverage within a capital structure until the optimum capital structure is achieved. The theory acknowledges the tax advantage from interest payments. This theory mainly refers to the two concepts – cost of financial distress and agency costs. A major objective of the trade-off theory is to explain the fact that businesses generally are funded partially with debt and partially with equity.

### Pecking Order Theory

According to pecking order theory (pecking order model), companies show a distinct preference for utilizing internal finance (as retained earnings or excess liquid assets) over external finance. If internal funds are insufficient to finance investment opportunities, a company might obtain external financing but it will choose among the various external finance sources in a manner as to minimize additional costs. This theory regards the market-to-book ratio as a way of measuring investment opportunities. This theory is made popular by Myers and Majluf as he claims that equity is a significantly less favored way to raise capital because when managers issue fresh equity, investors feel that managers think that the company is overvalued and managers are taking advantage of this over-valuation. Because of this, investors will place a reduced value to the new equity issuance.