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Optimal Capital Structure

Step-by-Step Guide to Understanding the Optimal Capital Structure

Last Updated October 1, 2023

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Optimal Capital Structure

What is the Definition of Optimal Capital Structure?

The optimal capital structure is the mixture of debt and equity that minimizes the cost of capital, while maximizing the firm value.

The composition of a company’s capital structure, or “capitalization,” is composed of debt, preferred stock, and common equity – which are the sources of funding used to finance core operations and the purchase of assets (i.e. capital expenditures).

The optimal capital structure is achieved when a firm’s cost of capital (WACC) is minimized and its firm value is maximized.

The trade-off theory states that firms must analyze the benefits from the tax-deductibility of debt to the potential risk of bankruptcy and financial distress.

Because of the trade-off between the tax benefits to debt from interest expense, each firm has an optimal capital structure, where its WACC is minimized and firm value is maximized.

How to Calculate Optimal Capital Structure?

Since the weighted cost of capital (WACC) is the blended required rate of return representative of all stakeholders of a firm, a lower WACC causes the firm valuation to increase (and vice versa).

  • Lower Cost of Capital (WACC) → Higher Firm Valuation
  • Higher Cost of Capital (WACC) → Lower Firm Valuation

Conceptually, the optimal capital structure reflects the trade-off between the benefits of using leverage – namely the tax-deductibility of interest expense and the lower cost of debt relative to the cost of equity – and the risk of relying on leverage.

Given a greater debt burden, all capital providers are placed at more risk because the underlying company can default on a financing obligation (and reach a state of “financial distress”).

With that said, the optimal corporate structure is the mixture of debt and equity where the WACC is minimized and the firm valuation is maximized.

Therefore, a management team with the incentive to maximize the firm value of their company should strive to alter their capitalization to meet their optimal capital structure at which the company’s weighted average cost of capital (WACC) is minimized.

Optimal Capital Structure Formula

The weighted average cost of capital (WACC) is the blended minimum required rate of return of a firm.

Cost of Capital (WACC) = [kd × (D ÷ (D + E))] + [ke × (E ÷ (D + E))]

Where:

  • WACC → Weighted Average Cost of Capital
  • kd → After-Tax Cost of Debt
  • ke → Cost of Equity
  • D / (D + E) → Debt Weight (%)
  • E / (D + E) → Equity Weight (%)

The optimal capital structure is commonly measured using the debt to equity ratio (or D/E ratio).

The debt to equity ratio (D/E) is a credit metric that measures the financial risk of a company by comparing its total debt to the value of its shareholders’ equity as prepared for bookkeeping purposes.

The formula to calculate the debt to equity ratio (D/E) is as follows.

Debt to Equity Ratio (D/E) = Total Debt ÷ Total Shareholders Equity

Conceptually, the debt to equity ratio (D/E) answers, “For each dollar of equity capital contributed, how much debt financing is there?”

Therefore, a debt-to-equity ratio (D/E) of 2.5x implies a company is financed with $2.50 of debt per $1.00 of equity.

In practice, the D/E ratio is usually plotted on a graph to track the trend in its trajectory over time.

There is no method to pinpoint the precise capital structure weights that reflect a company’s optimal capital structure because the measure is subjective to the practitioner performing the analysis (and there are many moving pieces).

By adjusting the debt to equity ratio (D/E) – the capitalization of the company – the factors that impact the cost of capital (WACC) move accordingly, such as the bankruptcy risk.

What Determines the Optimal Capital Structure?

The determinants of the optimal capital structure for a company is contingent on several factors.

  • Corporate Lifecycle → The capital structure of a company tends to shift toward a greater proportion of debt as opposed to equity in the latter stages of its lifecycle. The stage at which a company is currently in its lifecycle often dictates its optionality to raise debt at reasonable rates. Early-stage companies, on the other hand, seldom carry traditional debt on their balance sheet for the aforementioned reasons.
  • Tax-Deductibility of Interest → Given the tax-deductibility of interest expense – where interest reduces the pre-tax income (EBT) line item on the income statement – an increase in leverage causes the firm valuation to initially rise. However, the tax savings are eventually offset by the risk of default, where existing and potential capital providers are placed at risk, i.e. the higher risk coincides with a higher required rate of returns to compensate for the incremental risk.
  • Business Risk → Business risk is the risk inherent to the operating performance of a firm, assuming no debt. For instance, changes in consumer preferences, changes in unit costs, and increased competition. Generally the greater a firm’s business risk, the less financial leverage there is in the optimal capital structure.
  • Bankruptcy Risk → Lenders are willing to offer debt at favorable terms to borrowers with low credit risk, where the risk of default is lower. Since “cheap” debt is readily available to borrowers with high credit ratings, the upward trajectory of the leverage ratio rising in tandem with maturity is deemed an ordinary occurrence. Conversely, early to mid-stage borrowers that are unprofitable or have limited profitability have a lower debt capacity and are more likely to receive unfavorable financing terms from lenders, assuming their request for debt is even approved in the first place.
  • Agency Costs → Agency costs refer to the risk of discrepancies forming between management and stakeholders, which is often termed the principal-agent problem, where differences in viewpoints can cause the company to incur steep losses (and a reduction in valuation). For instance, managerial attitudes can diverge from the general consensus of its shareholder base, i.e. conservative cost-cutting vs. aggressive growth tactics.
  • Lender Risk-Appetite (Tolerance) → Most risk-averse lenders, namely banks, prioritize capital preservation, even if it means receiving a lower yield on a lending arrangement. If an early-stage company has yet to exhibit a track record of profitability and positive free cash flow (FCF), the decision to provide debt – which comes attached with periodic interest obligations over the borrowing term and debt service (e.g. principal repayment) – is a high-risk decision.

Optimal Capital Structure Graph

As more debt is incrementally added to the capital structure, the risk to all company stakeholders increases – all else being equal.

Starting from an all-equity capital structure, as the proportion of debt increases, the WACC initially declines because debt is a “cheaper” source of funding compared to equity.

However, if the corporation continues to borrow more and its D/E ratio expands, it is inevitable for the borrower to reach an inflection point where the bankruptcy risk outweighs the tax benefits.

Credit and default risk rise with increased leverage, which subsequently causes WACC to increase.

The trade-off theory of capital structures states that corporations should optimize their reliance on debt and equity to minimize the firm’s weighted average cost of capital (WACC), which in turn maximizes firm value.

According to the trade-off theory, if the bankruptcy risk becomes unmanageable, a firm must urgently reduce its debt burden, or else it is at risk of defaulting on its financial obligations.

  1. Initial Stage → As the proportion of debt in the capital structure increases, WACC gradually decreases due to the tax-deductibility of interest expense (i.e., the “tax shield” benefits).
  2. Optimal Capital Structure → The WACC continues to decrease until the optimal capital structure is reached (i.e. the “inflection point”)
  3. Bankruptcy Risk → Once the minimum threshold for debt is surpassed, the cost of potential financial distress offsets the tax advantages of debt, and the cost of capital (WACC) will reverse course and start climbing in an upward trajectory as the risk to all stakeholders increases.

Optimal Capital Structure Graph

Optimal Capital Structure (Source: Soleadea)

Cost of Equity vs. Cost of Debt: What is the Difference?

The cost of equity and cost of debt is the minimum required rate of return for shareholders and lenders, respectively.

  • Cost of Debt (kd) → The cost of debt is initially lower than the cost of equity because interest expense is tax-deductible. In contrast, issuances of dividends to shareholders are not tax-deductible.
  • Cost of Equity (ke) → The cost of equity is higher than the cost of debt (kd) because the capital cost attributable to debt – i.e. interest expense – is tax-deductible, creating a “tax shield.”

Unlike lenders, equity shareholders are not guaranteed any income (e.g. common dividends), and are last in line to receive funds in the event of default and liquidation.

In fact, with regard to the capital structure (and pecking order), common equity is positioned at the bottom of the capital structure, meaning the risk-return profile is the highest.

Therefore, the greater the debt burden of debt in a company’s capitalization, the more financial risk is placed on common shareholders, the stakeholder group with the lowest priority in repayment.

However, the fact that the cost of debt is “cheaper” does not imply that the optimal capital structure should be composed entirely of debt, because, unlike equity, debt introduces the risk of bankruptcy and financial distress.

Corporations are not obligated to issue dividends to shareholders, whereas lenders are entitled to receive periodic interest payments and principal amortization per the lending agreement.

  • Fixed Costs → Debt issuances cause financial risk to rise because the securities impose a fixed cost in the form of interest payments and/or mandatory principal amortization.
  • Loan Covenants → Besides the risk of a company becoming overburdened with leverage, secured loans often come with covenants that function as constraints to prevent certain corporate actions and ensure the borrower does not breach pre-defined leverage or interest coverage ratios.
  • Volatility in Performance → The other drawback to debt, aside from the fixed debt service, is that higher leverage causes more volatile returns in both directions. For instance, if a firm’s capitalization is composed of a substantial percentage of debt, a decline in operating income (EBIT) results in a more than proportional decrease in earnings per share (EPS).

What Factors Affect the Capital Structure Decision?

The following factors affect the capital structure decision among corporations.

  • Free Cash Flow (FCF) → The capital structure of a company often reflects its current fundamental profile, such as its historical and projected profit margins and its expected capacity to continue generating free cash flow (FCF). The free cash flows (FCFs) of the company must be sufficient to cover its debt service obligations on time.
  • Economic Moat → The capital structure of a market leader with a sustainable economic moat is likely to carry a greater proportion of debt on its capital structure.
  • Historical Profitability → Given the competition in certain industries, a company with a consistent track record of historical profitability and generation of free cash flow (FCF) has likely carved itself a sustainable moat that contributes toward the production of long-term profits and market share protection.
  • Collateral (Fixed Asset Base) → The collateral of the company is also influential on the capital weights of a company. Companies that operate with business models where the core value stems from tangible assets, rather than intangible assets, can secure debt financing more easily. While there are exceptions, a significant fixed asset base can be favorable for borrowers because in the event of default, the lender possesses the right to seize the pledged collateral (and recoup most of their original investment or to otherwise be repaid in full).
  • Tangible Assets → In short, the more reliant on intangible assets a company’s operating performance is, the less likely management is to use debt as a funding source. Unlike tangible assets, which can be physically touched, intangible assets for the most part cannot be pledged as collateral.

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