Optimal Capital Structure

FIN 609A
NUSD, 2010

y 1. What is optimal capital


y 2. Why is it important for the


y 3. How do we define the optimal

capital structure?

y Capital structure is defined as a firm's

ratio of debt to equity in its financing activities

y Optimal capital structure is the

proportion of debts and equities that maximizes the firm·s value while minimizing the average cost of capital.

y The goal

maximize profit. , or decreasing cost .

y By increasing sales

One of the way is to lower cost of capital => to optimize capital structure: to use equity, debt or combination of them.
Each of the source has it·s advantages and disadvantages for the business.

Advantages y debt does not dilute the owner's y ownership interest in y has no direct claim on future profits y y can be forecasted and planned y deducted on the company's tax return Disadvantages y debt must be repaid, usually with interest y the larger a company's debt-equity ratio, the more risky the company is considered by lenders and investors y it s difficult to make regular loan payments with irregular cash flows

the business is not obligated to repay the money the involvement of high-profile investors may also help increase the credibility of a new business.


ownership interests become diluted, managers face a possible loss of autonomy or control

How to find?
y Theories:

1) Modigliani and Miller theory 2) trade off theory 3) the agency cost theory 4) pecking order theory and many others

Modigliani and Miller theory
y Modigliani ² 1985, Nobel Prize

In the absence y of taxes, y bankruptcy costs, y and asymmetric information, the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments: whether the company·s capital consists of equities or debts, or a combination of them, or what the dividend policy is.

Research results:
y There were and are a lot of researches to find optimal capital

y Most of capital structuring theories operate under various

assumptions, such as no taxes, rational investors, perfect competition etc. However, the actual marketplace is quite different.
y There is no common formula for the optimal capital

structure, but some experts suggest ratio debt to equity close to 1:1 - 1:2

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