Optimal capital structure

Corporate finance deals with the strategic financial issues associated with achieving this goal, such as how the corporation should raise and manage its capital, what investments the firm should make, what portion of profits should be returned to shareholders in the form of dividends, and whether it makes sense to merge with or acquire another firm.

Optimal capital structure

This section does not cite any sources. Please help improve this section by adding citations to reliable sources. Unsourced material may be challenged and removed. July Learn how and when to remove this template message Consider a perfect capital market no transaction or bankruptcy costs; perfect information ; firms and individuals can borrow at the same interest rate; no taxes ; and investment returns are not affected by financial uncertainty.

Modigliani and Miller made two findings under these conditions. That is, as leverage increases, risk is shifted between different investor classes, while total firm risk is constant, and hence no extra value created.

Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax systemthe tax-deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases.

The optimal structure would be to have virtually no equity at all, i. In the real world[ edit ] If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its Optimal capital structure.

Optimal capital structure

Trade-off theory[ edit ] Trade-off theory of capital structure allows bankruptcy cost to exist as an offset to the benefit of using debt as tax shield. It states that there is an advantage to financing with debt, namely, the tax benefits of debt and that there is a cost of financing with debt the bankruptcy costs and the financial distress costs of debt.

This theory also refers to the idea that a company chooses how much equity finance and how much debt finance to use by considering both costs and benefits.

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The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

It states that companies prioritize their sources of financing from internal financing to equity according to the law of least effort, or of least resistance, preferring to raise equity as a financing means "of last resort". Thus, the form of debt a firm chooses can act as a signal of its need for external finance.

As a result, investors may place a lower value to the new equity issuance. Capital structure substitution theory[ edit ] The capital structure substitution theory is based on the hypothesis that company management may manipulate capital structure such that earnings per share EPS are maximized.

The SEC rule 10b allowed public companies open-market repurchases of their own stock and made it easier to manipulate capital structure.

The Optimal Use Of Financial Leverage In A Corporate Capital Structure | Investopedia

First, it has been deducted[ by whom? The second prediction has been that companies with a high valuation ratio, or low earnings yield, will have little or no debt, whereas companies with low valuation ratios will be more leveraged.

This contradicts Hamada who used the work of Modigliani and Miller to derive a positive relationship between these two variables. Agency costs[ edit ] Three types of agency costs can help explain the relevance of capital structure. As debt-to-equity ratio increases, management has an incentive to undertake risky, even negative Net present value NPV projects.

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This is because if the project is successful, share holders earn the benefit, whereas if it is unsuccessful, debtors experience the downside. If debt is risky e. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value.

Increasing leverage imposes financial discipline on management.

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Managerial contracts, debt contracts, equity contracts, investment returns, all have long lived, multi-period implications.The study of a company’s optimal capital structure dates back to when Franco Modigliani and Merton Miller published their Nobel Prize winning work “The Cost of Capital, Corporation.

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Capital Structure

Thesis-Driven Investing. The optimal capital structure indicates the best debt-to-equity ratio for a firm that maximizes its value.

Putting it simple, the optimal capital structure for a company is the one which proffers a balance between the idyllic debt-to-equity ranges thus minimizing the firm’s cost of capital. Capital Oral & Facial Surgery Center For Dental Implants Oral Surgeon Raleigh NC | Holly Springs NC | Wake Forest NC | Burlington NC.

The oral and maxillofacial surgeons at Capital Oral & Facial Surgery manage a wide variety of problems relating to the mouth, teeth and facial regions. Finding the Right Financing Mix: The Capital Structure Decision Aswath Damodaran Stern School of Business.

Aswath Damodaran 2 Optimum Capital Structure and Cost of Capital Estimate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price. The optimal capital structure is the mix of debt and equity that maximizes a firm’s return on capital, thereby maximizing its value.

Learning Objectives Explain the influence of a company’s cost of capital on its capital structure and therefore its value.

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