Capital Structure The Optimal Financial

What is the optimal mix of debt and equity for a firm? While in the last chapter we looked at the qualitative trade off between debt and equity, we did not develop the tools we need to analyze whether debt should be 0%, 20%, 40% or 60% of capital. Debt is always cheaper than equity, but using debt increases risk in terms of default risk to lenders, and higher earnings volatility for equity investors. Thus, using more debt can increase value for some firms and decrease value for others, and for the same firm, debt can be beneficial up to a point and destroy value beyond that point. We have to consider ways of going beyond the generalities in the last chapter to specific ways of identifying the right mix of debt and equity.

In this chapter, we explore three ways to find an optimal mix. The first approach begins with a distribution of future operating income; we can then decide how much debt to carry by defining the maximum possibility of default we are willing to bear. The second approach is to choose the debt ratio that minimizes the cost of capital. Here, we review the role of cost of capital in valuation and discuss its relationship to the optimal debt ratio. The third approach, like the second, also attempts to maximize firm value, but it does so by adding the value of the unlevered firm to the present value of tax benefits and then netting out the expected bankruptcy costs. The final approach is to base the financing mix on the way comparable firms finance their operations.

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