3. What is the Optimal Capital Structure?

occurs when a company’s increased use of borrowed funds (debt capital) sees the company’s equity generate greater income than the cost of borrowing.

• Assumption:

  • The cost of debt is lower than the cost of equity.

  • The risk perception of investors does not change with the use of debt.

  • No personal or corporate income taxes exist.

• leverage will result in the following change to a company’s value: if the ratio of debt to equity is increased, the cost of capital will decline while the value of the company as well as the share price will increase. This is true in the reverse: a decrease in the debt to equity ratio = increase in the cost of capital and decrease in the company value and share price. Hence, a company can minimize the cost of capital and increase the value of the company by debt financing to the maximum possible extent

• assumes that the capital structure is irrelevant and unrelated to a company’s value. based on the following assumptions:

  • The cost of debt is lower than the cost of equity.

  • Risk perception of lenders of debt does not change with the leverage and as a result, the cost of debt remains constant.

  • The market determines the value of a company as a whole, which means that the split between debt and equity is irrelevant.

  • No personal or corporate income taxes exist.

Because of the risk perception of the owners, they will expect higher returns if the amount of debt increases. In turn, this will offset any savings from lower costs for debt and in total, the capital costs are constant irrespective of the financing structure. Since any change in the capital structure does not affect the overall cost of capital for a company as a result, the market value does not change

• developed as a form of compromise between the net income approach and the net operating income approach

• Assumption: an optimal debt ratio (leverage) exists for any company when the average cost of capital is minimized

• Granted that the average cost of capital is used as a discounting factor for income, a company’s valua-

  tion is maximized when its cost of capital is minimized.

• The traditional theory states that an increase in a company’s debt proportion or leverage ratio increases the required rate of return for equity holders.

• Effect 1: Expensive equity is replaced by cheap debt. As long as the cost of equity and cost of debt remain constant (at the beginning of the substitution), a company’s average cost of capital decreases

• Effect 2: The risk for the tied equity increases, as the debt-equity ratio increases. As a result, a higher return is required. The return on equity is rising, but the average cost of capital continues to decline (as there is still no overcompensation of the redistribution of equity into debt by increasing the return requirement of the distributors of equity)

• Effect 3: Distributors of debt capital regard the increasing and high debt as critical and demand a risk premium. As a result, the debt interest rate rises. This will increase the total cost of capital.

→The first effect is a reduction in a company’s average cost of capital. The other two effects

increase the average cost of capital based on rising debt.

• An increase in use of debt means the overall cost of capital falls and the value of the company increases.

• This effect is temporary, because the total costs of capital rise as debt levels increase further, and the value of the company decreases (from point M onwards).

• The optimal debt-equity ratio therefore occurs at D/VE*, where the overall cost of capital is minimized and the company value is maximized.

shows that the traditional theory is unverifiable. The idea that investors identify the rising risk inherent to the rising proportion of debt is just as plausible as the idea that they will eventually look to offset this by increasing the rate of return requirements. In practice however, the expected gains are not measurable. Equally, borrowing or repaying capital does not serve the purpose of substituting one type of capital for another.

• under perfect market conditions, the market value of a company cannot be increased by altering the claims on its assets, i.e., by changing its debt-equity ratio. -> A company’s capital structure is therefore irrelevant

• starting point of the modern thinking on capital theory

assumptions:

• An investment policy is taken as given.

• Investors demand a certain average gross return on their investment. Although questionable in practice, this model assumes that all investors have the same expectations for their investment.

• Companies can be divided into homogeneous risk classes. Within these risk classes, the risk of possible fluctuations in gains over time is the same.

• Allocating a company to a certain risk class permits a comparison with the known market values of other companies in the same risk class. Business risk and debt risk can be assessed individually for their impact on market value.

• A perfect efficient capital market exists. For any two companies in the same risk class that do not carry debts, their average cost of capital will be the same, and the price per share of expected profits as well as the company value are the same. There are no capital market restrictions. All participants have equal access to the capital market. Financing instruments are freely available to all. Financing instruments are infinitely divisible. There are no information or transaction costs.

• Equity investors have expectations in terms of their effective returns. Due to the formation of risk classes, differences in the valuation of companies can be attributed exclusively to different business risks.

• Borrowing costs are independent of the debt-equity ratio, whereby shareholders can take on debt at the same rates as companies.

• The interest rate on capital investments and borrowing is uniform. • Companies either can finance their operations through risk-free debt capital or via equity capital that is exposed to risk.

• Cash flows are assumed to continue in perpetuity.

• can be seen in the company’s cost-of-equity rate, which does not remain constant even if there is a change in the

  amount of risk-free securities issued

• irrelevance of company capital structure also extends to a company’s dividend policy.

• assuming a perfect capital market, that dividend policy can be understood as a balance between self-financing by retaining earnings and profit distribution followed by issuing new shares.

• Because the value of a company can be calculated by multiplying the stock price by the number of stocks, there is a direct link between an increase in the dividend and an issuing of new shares.

• company’s market value, following an increase in its capital and a dividend payout, is calculated as the total sum of the values of the old and new shares. However, since rational shareholders adopt an indifferent attitude to dividend payments and share price increases caused by retention of earnings, the dividend policy has no effect on the company’s value.

If different tax rates for retained and distributed profits exist and the tax rate for distributed profits is lower than for retained profits, it makes sense to distribute profits first and to appeal to the shareholders to ask them to reinvest these profits in the company

in the form of new capital

The capital structure corresponds to the debt-equity ratio (D/E) and is defined as the ratio of debt capital (D) to equity (E). This gives us the debt-equity ratio D/E. There is a relationship between return on equity and debt ratio.

The correlation between the return on equity and the proportion of debt is known as the leverage effect.

There are different theories regarding capital structure which state either that an optimal debt-equity ratio exists or that it does not.

• The traditional theorem calculates the optimum debt-equity ratio, and hence optimal capital structure, as occurring when total capital costs are minimized and the value of the company is maximized.

• The theorem advanced by Modigliani and Miller says that a company’s capital structure is irrelevant to the value of the company and that it is equally irrelevant to dividend payouts. According to their theorem, no optimal debt-equity ratio exists.

• The neo-institutional theory is closer to reality and takes account of taxes and bankruptcy costs. This theory can be used to calculate an optimal debt-equity ratio.

Theories can never make assumptions that cover all real-world realities. Therefore, in practice it is only possible to arrive at an approximate figure for the optimal debt-equity ratio. In order to make this approximate calculation, a company is taken which is assumed to be debt-free, the present value of all costs is subtracted, and the present value of the tax benefit is added.