What is the optimal mix of debt and equity for a firm? While in the last chapter we looked at the qualitative trade off between debt and equity, we did not develop the tools we need to analyze whether debt should be 0%, 20%, 40% or 60% of capital. Debt is always cheaper than equity, but using debt increases risk in terms of default risk to lenders, and higher earnings volatility for equity investors. Thus, using more debt can increase value for some firms and decrease value for others, and for the same firm, debt can be beneficial up to a point and destroy value beyond that point. We have to consider ways of going beyond the generalities in the last chapter to specific ways of identifying the right mix of debt and equity.

In this chapter, we explore three ways to find an optimal mix. The first approach begins with a distribution of future operating income; we can then decide how much debt to carry by defining the maximum possibility of default we are willing to bear. The second approach is to choose the debt ratio that minimizes the cost of capital. Here, we review the role of cost of capital in valuation and discuss its relationship to the optimal debt ratio. The third approach, like the second, also attempts to maximize firm value, but it does so by adding the value of the unlevered firm to the present value of tax benefits and then netting out the expected bankruptcy costs. The final approach is to base the financing mix on the way comparable firms finance their operations.

The operating income approach is the simplest and one of the most intuitive ways of determining how much a firm can afford to borrow. We determine the firm\u2019s maximum acceptable probability of default. Based upon the distribution of operating income, we then determine how much debt the firm can carry.

We begin with an analysis of a firm\u2019s operating income and cash flows, and we consider how much debt it can afford to carry based upon its cash flows. The steps in the operating income approach are as follows:

1. We assess the firm\u2019s capacity to generate operating income based upon both current conditions and past history. The result is a distribution for expected operating income, with probabilities attached to different levels of income.

4. We set a limit on the probability of its being unable to meet debt payments. Clearly, the more conservative the management of the firm, the lower this probability constraint will be.

5. We compare the estimated probability of default at a given level of debt to the probability constraint. If the probability of default is higher than the constraint, the firm chooses a lower level of debt; if it is lower than the constraint, the firm chooses a higher level of debt.

The average change in operating income on an annual basis over the period was 10.09%, and the standard deviation in the annual changes is 19.54%. If we assume that the changes are normally distributed, these statistics are sufficient for us to compute the approximate probability of being unable to meet the specified debt payments.

billion by assuming that the debt will be rated BBB, lower than Disney\u2019s current bond rating of BBB+1. Based upon this rating, we estimated an interest rate of 5.5% on the debt. In addition, we assume that the sinking fund payment set aside to repay the bonds is 5% of the bond issue. This results in an annual debt payment of $ 550 million\u2013