Optimal Capital Structure

Overview

The optimal capital structure is the one that maximizes the value of the firm to owners of the firm. (that is, both the debt holders and the equity holders).

Under certain ideal considerations, all capital structures are equivalent. However, theory suggests that under real world considerations, there is an optimal point.

Modigliani Miller

The Modigliani Miller theorem asserts that under a set of specified conditions,

• no taxes
• no bankruptcy costs
• symmetric information
• equal borrowing costs

the value of a firm is independent of capital structure.

Practical Considerations

When there are taxes, and in particular, when interest on debt is tax shielded, then the theorem no longer holds. Instead, the company saves money from netting interest payments against revenue in its profit calculation, which creates additional value in the form of a tax shield. (this requires that the company is profitable enough so that the interest payments effectively saves the firm from taxes.)

The tax shield incentivizes the firm to finance as much of the company as possible using debt. There are other considerations though. If the firm faces bankruptcy costs, the expected value of those costs must be netted against the gain from the tax shield. That is, as the firm takes on more leverage, the probability of bankruptcy goes up, and the expected costs of bankruptcy rise, creating any offset against any gain in the tax shield.

When the expected bankruptcy costs as a function of leverage is non-linear, then there will likely be an optimal capital structure, characterized by the point where the expected bankruptcy curve crosses the tax shield curve.

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Leverage

The operating leverage is defined as

• {% FC %} = fixed costs
• {% TC %} = Total costs (fixed plus variable)