Does Optimal Capital Structure exist?

This article provides a historical perspective on the use of debt by American corporations and its
impact on firm value. The author discusses the growing use of debt in the 1980s, exemplified by
notable deals such as the purchase of Kraft by Phillip Morris and the leveraged buyout of RJR
Nabisco. It questions the impact of debt on firm value, the differences between firms with varying
capital structures, and the existence of an optimal capital structure.

If we look at the historical trends in corporate debt levels, they were relatively high during the 1930s,
declined during World War II, and have risen consistently since then. However, since 1970, the trend
seems to have leveled off, although the debt level remains historically high.

Variability of debt-to-capital ratios across industries and over time can also be observed. Industries
such as utilities have relatively high debt ratios, while others like printing and publishing have low
debt ratios. Within industries, variations in debt ratios can be observed. These differences complicate
the determination of an appropriate level of debt and optimal capital structure.

Business risk also has an influence on the use of debt. Firms operating in businesses with highly
variable earnings (EBIT) tend to use less debt. The degree of operating leverage (DOL) is used as a
measure of EBIT variability, with higher DOL indicating greater sensitivity of EBIT to changes in sales.
Businesses with high fixed costs have high DOL, making them more sensitive to sales fluctuations
and likely to have lower levels of debt.

The document acknowledges the ongoing debate regarding the impact of capital structure on firm
value. While some theories, such as the Modigliani-Miller theorem, argue that capital structure is
irrelevant to firm value in the absence of taxes and financial distress costs, empirical studies have
shown mixed results, indicating that capital structure decisions do have implications for firm value.

It highlights the trade-offs involved in using debt as a source of financing. Debt can provide tax
advantages through interest deductions and leverage potential returns, but it also introduces
financial risk and potential constraints on future borrowing capacity.

Market conditions and investor sentiment can significantly influence the availability and cost of debt
financing. During periods of economic expansion and favorable market conditions, companies may
be more likely to take on higher levels of debt. Conversely, during economic downturns or periods of
financial instability, companies may face challenges in accessing debt capital.

The relationship between debt levels and firm value is not linear. While an increase in debt initially
enhances firm value due to the benefits of financial leverage, there comes a point at which
additional debt becomes detrimental and increases the risk of financial distress. Finding the optimal
capital structure that maximizes firm value requires balancing these competing factors.

It is important to consider a company's unique characteristics, industry dynamics, and business risk
when making capital structure decisions. Industries with stable cash flows and low business risk may
be able to handle higher debt levels, while industries with high volatility and uncertain prospects
may opt for more conservative capital structures.

Capital structure decisions can be influenced by factors beyond financial considerations, such as
managerial preferences, corporate governance, and market expectations. For example, some
managers may have a personal aversion to high debt levels, leading to more conservative capital
structures.
Thus it can be said that question of an optimal capital structure remains unresolved. The impact of
debt on firm value is complex and context-dependent, requiring a thorough analysis of various
factors and trade-offs.

Key Learnings:

The 1980s witnessed a significant increase in the use of debt by American nonfinancial corporations.
This trend attracted attention and raised questions about the impact of debt on firm value.

Historical analysis shows that debt levels have fluctuated over time, but since 1970, the trend has
stabilized at a historically high level.

Book-value and market-value ratios of debt often differ, highlighting the importance of considering
different perspectives when assessing capital structure.

Different industries exhibit varying debt-to-capital ratios, with utilities generally having higher debt
ratios and printing and publishing industries having lower debt ratios.

Business risk, as measured by the degree of operating leverage (DOL), influences the use of debt.
Businesses with high fixed costs and high DOL tend to have lower levels of debt due to the higher
variability of their earnings.

Determining an optimal capital structure that maximizes firm value remains unresolved. Industry
averages and individual business characteristics play a significant role in determining an appropriate
level of debt.