Optimal capital structure is mix of debt and equity which maximizes the value of the firm
or minimizes the cost of capital. Examples:
Value of firm in general:
V = CF/R
R = r + ? + RP
RP = risk premium
Value of firm:
Free Cash Flow:
- tax on EBIT (tax rate * EBIT)
- capital expenditures
- increase in working capital
FREE CASH FLOW
The capital structure of the firm is the mix of debt and equity that the firm uses to finance its operations. Most firms are financed by a combination of debt and equity.
Cost of debt rD = 0.08
Cost of equity rE = 0.146
Marginal tax rate TC = 0.35
Debt ratio = 0.4
Equity ratio = 0.6
WACC = 0.08(1 – 0.35)(0.4) + (0.146)(0.6) = 0.1084 or 10.84 %
Leverage ratio D/(D +E) should be the target capital structure in market values for the particular project
V= FCF1/(1 + WACC) + FCF2/(1 + WACC)2 + ..+ FCFn/(1 + WACC)n
Steps to calculate WACC
1. Cost of equity by using CAPM
2. Cost of debt by calculating yield to maturity of the debt
3. Calculating WACC
Trade off theory:
There is an optimal capital structure, target capital structure, that trade off the benefits
and the costs of debt and maximizes the firm value.
Modigliani, Miller –theory:
Captial structure does not change firm value.
Pecking Order Theory:
Firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity a last resort.
The pecking order:
1. Internal cash flow
2. Issue debt
3. Issue equity
Agency theory derives from the fact that decisions within firms are made by management,
who are agents for investors. Information asymmetry, conflicting interests between management and investors can lead suboptimal allocation of resources within the firm.